Andrew Michael reports that the pound has kept rising and global stock markets have also gone up slightly after US inflation dropped more than expected (see the story below) and caused the dollar to lose value.
The pound increased by 0.5% against the dollar in early trading today – reaching a 15-month peak of $1.305 – as investors expected the US Federal Reserve to lower interest rates in early 2024.
Stocks in Europe also gained after Asian markets closed higher and US stocks reached their best levels in over a year. The Stoxx 600 index, which covers Europe, went up by 0.3% in early trading today, after going up by 1.5% on Wednesday, its biggest one-day increase in almost two months. https://www.forbes.com/uk/advisor/personal-finance/2023/07/19/inflation-rate-update/
US stocks also did well on Wednesday, with the S&P 500 index ending at its highest level in 15 months, with large tech companies leading the charge.
This came after the latest official data showed that US inflation was 3% in the year to June 2023, the lowest annual rate since March 2021.
This means that after the Fed raised interest rates several times, annual US inflation is getting closer to the central bank’s long-term goal of 2%. The Bank of England, which also aims to keep inflation at 2%, has raised interest rates 13 times since December 2021, but UK inflation is still high at 8.7%.
The Fed will announce its next interest rate decision on July 26, and the Bank of England will do the same a week later.
How does inflation affect stock returns?
Inflation is the general rise in the prices of goods and services over time. It reduces the purchasing power of money and erodes the real value of savings and investments. Inflation can have both positive and negative effects on the economy and the stock market, depending on its level, causes and expectations.
In general, moderate and stable inflation can be beneficial for economic growth and stock returns, as it reflects healthy consumer demand, encourages business investment and innovation, and allows for gradual wage increases and debt repayment. However, high and volatile inflation can be harmful, as it increases uncertainty, reduces consumer confidence and spending power, squeezes corporate profits and margins, and prompts monetary policy tightening that can slow down growth and employment.
The relationship between inflation and stock returns is complex and varies across countries, sectors, industries and time periods. It depends on several factors, such as:
• The source of inflation: whether it is driven by demand shocks (such as fiscal stimulus or consumer spending) or supply shocks (such as oil price spikes or natural disasters).
• The degree of inflation: whether it is low, moderate or high; expected or unexpected; stable or unstable.
• The monetary policy response: whether it is accommodative (lowering interest rates or expanding money supply) or restrictive (raising interest rates or contracting money supply).
• The market perception: whether investors view inflation as a sign of economic strength or weakness; whether they anticipate future inflation or deflation; whether they adjust their expectations and portfolios accordingly.
Historical case studies of inflation and stock markets
To illustrate how inflation can affect stock returns in different ways, let us look at some historical case studies from various countries and time periods.
Case study 1: US stagflation in the 1970s
The US experienced a period of high inflation and low growth in the 1970s, known as stagflation. This was caused by a combination of factors, such as:
• The oil price shocks of 1973 and 1979, which increased energy costs and disrupted production.
• The Vietnam War and the Great Society programs, which expanded government spending and deficits.
• The Nixon shock of 1971, which ended the Bretton Woods system of fixed exchange rates and allowed the dollar to depreciate.
• The wage-price spiral, which created a feedback loop between rising wages and prices.
The Fed initially responded to inflation by lowering interest rates to stimulate growth, but this only fueled more inflation. It then switched to a more restrictive policy under Paul Volcker in 1979, raising interest rates to unprecedented levels to curb inflation. This caused a severe recession in 1980-1982, but also brought down inflation from double digits to single digits by 1983.
The stock market performed poorly during this period of stagflation. The S&P 500 index had a negative real return of -4.3% per year from 1973 to 1982
https://www.imf.org/-/media/Files/Publications/WP/2021/English/wpiea2021219-print-pdf.ashx. The sectors that suffered the most were those that relied on energy inputs or had high fixed costs, such as utilities, transportation and manufacturing. The sectors that did better were those that had pricing power or benefited from lower real interest rates, such as health care, consumer staples and technology.
Case study 2: Japan’s deflation in the 1990s
Japan experienced a period of low inflation and low growth in the 1990s, known as deflation. This was caused by a combination of factors, such as:
• The bursting of the asset price bubble in 1990, which led to a collapse in real estate and stock prices, a banking crisis and a balance sheet recession.
• The appreciation of the yen, which reduced export competitiveness and profitability.
• The fiscal policy paralysis, which prevented adequate stimulus and structural reforms.
• The monetary policy inertia, which kept interest rates too high and failed to provide sufficient liquidity and credibility.
The Bank of Japan (BOJ) initially responded to deflation by lowering interest rates to zero in 1995, but this was not enough to revive growth and inflation. It then adopted unconventional measures, such as quantitative easing (QE) in 2001 and forward guidance in 2006, but these were also insufficient and inconsistent. It was not until 2013 that the BOJ launched a more aggressive and comprehensive policy framework, known as Abenomics, which aimed to achieve a 2% inflation target through massive QE, fiscal stimulus and structural reforms.
The stock market performed poorly during this period of deflation.
The Nikkei 225 index had a negative real return of -6.9% per year from 1990 to 2012
https://www.investopedia.com/articles/investing/052913/inflations-impact-stock-returns.asp.
The sectors that suffered the most were those that were exposed to the domestic economy or had high debt levels, such as financials, real estate and industrials. The sectors that did better were those that had global markets or competitive advantages, such as technology, health care and consumer discretionary.
Case study 3: Emerging markets’ hyperinflation in the 1980s and 1990s
Several emerging markets experienced periods of very high inflation and low growth in the 1980s and 1990s, known as hyperinflation. This was caused by a combination of factors, such as:
• The external debt crisis of the early 1980s, which triggered currency devaluations, capital flight and balance of payments problems.
• The fiscal policy profligacy, which led to large budget deficits, money printing and loss of fiscal discipline.
• The monetary policy passivity, which allowed inflation expectations to become unanchored and inflation inertia to persist.
• The political and social instability, which undermined confidence and governance.
Some of the most extreme cases of hyperinflation occurred in Latin America (such as Argentina, Brazil, Bolivia and Peru) and Eastern Europe (such as Russia, Ukraine and Yugoslavia). In some cases, inflation reached millions or even billions of percent per year, wiping out the value of money and savings.
The central banks of these countries eventually responded to hyperinflation by adopting stabilization programs that involved:
• A nominal anchor, such as a fixed exchange rate regime (e.g., Argentina’s currency board), a monetary aggregate target (e.g., Brazil’s Real Plan) or an inflation target (e.g., Peru’s IT regime).
• A fiscal adjustment, such as reducing spending, increasing taxes or restructuring debt.
• A structural reform, such as liberalizing markets, privatizing state-owned enterprises or strengthening institutions.
The stock market performed poorly during this period of hyperinflation. The MSCI Emerging Markets index had a negative real return of -8.7% per year from 1988 to 1999https://www.imf.org/en/Publications/WP/Issues/2021/08/20/Stock-Returns-and-Inflation-Redux-An-Explanation-from-Monetary-Policy-in-Advanced-and-463391. The sectors that suffered the most were those that were vulnerable to currency risk or had low profitability, such as utilities, materials and energy. The sectors that did better were those that had hard currency revenues or had high growth potential, such as technology, telecommunications and consumer discretionary.
Inflation can have different effects on stock returns depending on its level, source, degree, monetary policy response and market perception. In general, moderate and stable inflation can be positive for stock returns, while high and volatile inflation can be negative. However, there are exceptions and variations across countries, sectors and time periods. Investors should be aware of the historical patterns and current trends of inflation and adjust their portfolios accordingly.
## References https://www.imf.org/-/media/Files/Publications/WP/2021/English/wpiea2021219-print-pdf.ashx: Stock Returns During Periods Of High Inflation And Low Growthhttps://www.investopedia.com/articles/investing/052913/inflations-impact-stock-returns.asp: Japan’s Stock Market: A Different Historyhttps://www.imf.org/en/Publications/WP/Issues/2021/08/20/Stock-Returns-and-Inflation-Redux-An-Explanation-from-Monetary-Policy-in-Advanced-and-463391: Stock Returns And Inflation Redux: An Explanation From Monetary Policy In Advanced And Emerging Markets
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