Inflation's Magic Number Is Four
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
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
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
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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