In last month’s newsletter I talked a bit about brewing inflation fears. Those fears increased in May as prices continued to do the same. That triggered some stock market volatility and a lot of debate about whether inflation might start to impede our economic recovery in the coming months—or even reverse it.
According to the U.S. Labor Department, prices today are rising faster than at any time since 2008.* Inflation has been a growing concern for months as our economic recovery from the pandemic has picked up speed. Remember, inflation is defined as “too much demand chasing too few goods and services.” A little inflation is generally seen as good because it means consumers are consuming. That fuels demand, which creates jobs, drives growth and, overall, signals a thriving economy.
However, there are always concerns of backlash. If prices rise too high too fast, people may stop spending and bring the economy to a grinding halt. That concern is increasing rapidly in households and corporate boardrooms across the country. A recent Shopkick survey found that 77% of Americans are feeling the effects of inflation and 54% are very concerned about it.**
Not surprisingly, all this worry has triggered some stock market volatility. On May 10th, the Dow Jones Industrial Average experienced a 1,200-point drop over two days. The S&P 500 and Nasdaq Index saw similar sharp declines, which most analysts attributed to worries about inflation.*** Though the market has rebounded since, as of this writing it remains below its peak high from May 10th, and has yet to regain the momentum it appeared to have before then.
Unfortunately, all this concern about inflation may not wane anytime soon. As tens of millions of people hit the road for Memorial Day weekend, they were dealing with the highest gas prices in six years. Prices on everything from hotdogs to beer to rental cars are above pre-pandemic levels, and plane tickets and hotel rates are quickly on their way.****
As I noted in last month’s newsletter, the driving forces behind today’s inflation spike are obvious. As Covid-19 infection rates have fallen and pandemic restrictions have eased, people are eager to get back to normal. In America, that means spending money—and after a year of forced frugality, many people have extra money to spend. At the same time, many companies are still recovering from slowdowns in production during the pandemic. Their inventories are low. Other businesses are short-staffed and struggling to fill open jobs. Put all that together and you have too much demand chasing too few goods and services, a.k.a. inflation.
As for Wall Street’s reaction, it’s not surprising. Inflation is usually seen as a negative force for the stock market for several reasons. It increases borrowing and material costs, and it may eventually decrease consumer spending, as I mentioned. Most importantly, it reduces expectations for earnings growth, which puts downward pressure on stock prices.
So, the big question is: will inflation continue to rile the current market or even trigger the next correction? No one knows for sure, but here are some important points to keep in mind. First, remember that the stock market doesn’t react to economic trends; it anticipates them. That being the case, investors typically expect a certain amount of inflation each year and factor it into their projected returns. Since the markets quickly stabilized after May’s volatility, it could indicate investors have now priced inflation into this market and made their peace with it.
Another important point is that Wall Street tends to react much more negatively to inflation when the economy is contracting or in a recession than when it is expanding like it’s doing now. Also, keep in mind that after rising steadily into late March, long-term interest rates have since stabilized. At the same time, the Fed has reaffirmed its commitment to keeping short-term rates near zero, and to open-ended quantitative easing. All these factors should help offset Wall Street’s worries about inflation even if prices continue to rise sharply in the coming months.
The Bigger Picture
As I also noted last month, I believe the inflation we’re seeing now is only temporary, and that big investors believe so, too. The force behind it is pent-up demand caused by the pandemic. Once consumers get it out of their systems, prices should stabilize again, and at that point the market could regain its early-year momentum. However, as I also pointed out, anything is possible in the New Age of Economic Uncertainty. That’s especially important to keep in mind when you’re in or nearing retirement because, while the immediate effects of inflation are always obvious, the long-term effects are more subtle and therefore more dangerous.
As you know, one of the main benefits of investing for income is that it can provide a much more effective way to manage the effects of inflation over many years than investing for growth.Income Specialists use a variety of strategies to help you keep pace with inflation and even stay ahead of it. Many income-based investment options offer built-in inflation protection, or your inflation hedge can often be engineered through the strategic reinvestment of interest and dividends you don’t need for income.
The bottom line, as always, is to make sure your current allocation is still right for your risk tolerance and aligned with your goals because—just like prices, interest rates, and all the other market forces—those things can change, too!
*“Inflation Speeds Up in April as Prices Leap 4.2%, Fastest Since 2008,” CNBC, May 12, 2021
**“83% of Americans Are Belt Tightening Due to Inflation Pressures,” Forbes, May 24, 2021
***“Inflation Spooks Stocks and Raises Fear the Fed is Wrong,” CNBC, May 12, 2021
****“Inflation Concerns are Nibbling at Sentiment,” Yahoo Finance, June 1, 2021