The Consumer Price Index (CPI) calculates the monthly change in prices for American consumers. It is a widely accepted measure of inflation. The CPI rose 8.6% from May 2021 to May 2022, the highest increase since 1981. But the record was short-lived as the Index rose by 9.1% in June 2022.
Will the sudden surge in inflation affect the stock markets, and if so, how?
The Dow dropped by 466 points when the inflation data was published, while the Nasdaq and S&P were down by 2% and 1.5%. However, there was a mild recovery.
To address inflation, the Fed raised its benchmark interest rate by 0.75%, the most aggressive hike since 1994. This means that borrowing becomes more expensive as the interest on debt instruments rises.
High inflation is usually considered bad for stocks. As we saw, companies must pay more to borrow money. The cost of inputs (labour and materials) rises. Businesses cannot pass on the higher costs immediately to their customers. This impacts profit expectations, thus lowering stock prices. High inflation makes the stock market volatile.
Mild inflation is actually good. Inflation makes consumers expect that prices will keep increasing. So, they buy now at lower prices. Short-term demand rises, so companies grow and hire to meet the increasing demand. This boosts economic growth and stock prices. This holds good as long as inflation stays within 2%.
When the central bank increases interest rates, the yield on savings and money market accounts also rises. This makes stocks less attractive as investors prefer to stash surplus funds in cash.
In summary, experts assume that stock prices will fall in the short term if inflation rises, and vice versa. However, there is no conclusive correlation.
Value stocks (stocks that are trading below what they are worth) perform better in times of high inflation. Growth stocks (expected to outperform in the long term because of potential) perform better when inflation is low. Additionally, the effect of inflation varies from sector to sector.
So, will the US stocks recover? Unfortunately, there is no crystal ball to answer this. Many factors affect stock prices, and inflation is only one of them.
Studies have shown that with high inflation, stocks do well immediately after inflation peaks. The stock market is mainly a forward-looking indicator.
The overall sentiment in the US economy is positive. Supply chain bottlenecks are easing up. Consumer spending is up. Prices of construction materials are falling. The labour market has plenty of jobs, and unemployment is at a 50-year low. Extended periods of high inflation are rare in America.
As a result, experts like JP Morgan’s senior analysts, Forbes, and money.com, all predict a quick stock market recovery. However, this assumes that the economy will not slip into a recession, in which case all bets are off.
Note: Please do not invest money or assets in the financial markets that you cannot afford to lose. This article should not be construed to be investment advice and is for information purposes only