By James Mackintosh 

Three may be the magic number, but it is four that obsesses the market. Specifically, inflation rising above 4% last week proved a shock for inflation-sensitive assets, with bond yields jumping and stocks falling, growth stocks most of all.

It might sound like yet another bit of market mysticism, alongside "cup and handle" patterns in charts or the people who try to divine price movements from the stars. But there is more than just a solid history of the market freaking out when inflation passes 4%; it has logic too.

The story goes like this. When inflation is low, rising inflation is a good thing for stocks. A pick up from 1% to 2% means the risk of falling into deflation -- a serious threat to the stock market -- has gone down, so share prices should go up. The market also tends to be especially sensitive to the economy when inflation is very low, because it generally means the economy is quite weak; a stronger economy pushes up inflation, and is good for stocks. The Federal Reserve is also happy to ignore rising inflation at this point, because it is what policy makers want.

As inflation rises further, the gains for stocks decrease, because deflation risk is forgotten and the prospect of a more active Fed counteracts the continued benefit from a stronger economy. But there's a tipping point where the gains from the economy are offset by the threat from the Fed, and that seems to be about 4%. Higher bond yields switch from being good for stocks to being bad for stocks, and the market focuses on the danger of inflation instead of the rewards from the economy that's creating that inflation.

We saw this last week, with stock prices and bond yields moving in opposite directions every day. The link between the two, measured as the correlation of their daily changes over the past 100 days, is the lowest in more than 15 years. Instead of more inflation being good news for stocks, it is now bad news -- while still being bad for bonds, meaning higher yields. Less concern about inflation now means lower Treasury yields, and higher stock prices.

The 4% logic isn't written in stone, but it has reasonable historic support. Since the S&P 500 was created in 1957 U.S. inflation has risen above 4% nine times, and in eight of those cases stocks were lower three months later. The exception, in 2005, saw inflation fall back below 4% again almost immediately, calming investors.

As in almost everything in investing, there are too few examples to rule out dumb luck; the S&P has fallen over three months about a third of the time. But the logic behind a shift in investor views at somewhere around 4% is pretty compelling, and it is certainly true that investors are worried about inflation now in a way that they weren't just a few short months ago.

The three questions investors need to ponder are whether the inflation will last, whether the Fed will act, and just how expensive stocks are. If this proves to be a temporary spike due to reopening demand and pandemic-related supply problems -- as I hope -- then history is kind. In 1984 and 2006 when inflation dropped back below 4%, stocks recovered all their losses.

If the Fed decides it doesn't need to step in, then stocks might be fine for a while even as inflation carries on up. Exactly this happened in 1968, when the boom continued for six months after inflation passed 4%, helped by declining bond yields.

Finally, there is the problem of stocks being extremely expensive. When bond yields finally started to rise and the 1960s boom ended, there was hell to pay for investors: The S&P lost more than a third of its value over the next 18 months. In 1987 the extreme run-up in stocks ended in a crash shortly after inflation passed 4%. In 2007 the bubble was in commodities, housing and debt rather than stocks, but the start of the decline in the S&P coincided almost exactly with inflation passing 4%, before turning into a financial crisis.

This time, stocks are extremely expensive on almost all measures. Worse, the U.S. market is dominated by big technology companies and other growth stocks that are very sensitive to bond yields and so likely to fall further if yields rise quickly. Cheap value stocks tend to outperform -- although not necessarily rise in absolute terms -- when inflation picks up, but will suffer particularly hard if Fed action to slow inflation hits the economy. For now, the best hope of investors is that the Fed sticks to its plan and inflation comes back down of its own accord.


(END) Dow Jones Newswires

May 18, 2021 12:38 ET (16:38 GMT)

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