The relationship between inflation and the economy and financial markets is a highly complex problem. Investors generally take a negative view of higher inflation because it often leads to higher borrowing costs and increases the discount rate applied to earnings, which in turn causes price-to-earnings (P/E) ratios to fall. According to Strategas, the sweet spot for earnings growth, which usually drives stock prices, is when inflation is between 2%-4%. In this range, the average quarterly earnings growth rate for the S&P 500® Index has historically been 9.2%. At higher inflation levels, S&P 500 quarterly earnings growth has been weaker; 7.0% when inflation is between 4%-6%, and 5.2% when inflation is between 6%-8% range.
Investors may worry about inflation’s impact on equities, but as the accompanying chart illustrates, equities generally act as an excellent buffer against inflation over time. From some perspective, the U.S. inflation rate, measured by the Consumer Price Index (CPI), averaged around 3.2% from 1914 to 2023. The S&P 500 Index, in comparison, returned a respectable 10.4% annual return (compound growth rate) from 1926 through 2022. Stocks may also offer some protection against inflation because company revenue and profits usually grow at the same rate as inflation. However, these increases can be offset by a contraction in profit margins as firms face higher input costs, dampened pricing power, or negative operating leverage. In other words, inflation can impact companies’ future profitability if they can’t cut costs or pass higher input costs on to end consumers.
It’s also worth noting that changes in the inflation rate can affect asset classes and sectors differently. For example, growth stocks generally underperform value stocks when inflation is high, and sectors such as utilities or information technology have historically demonstrated a negative correlation with inflation. Nevertheless, investors may want to consider how equities can enhance their portfolios as a hedge against inflation, while maintaining a diversified and balanced portfolio aligned with their risk tolerance and long-term goals.
This material is not a recommendation to buy or sell a financial product or to adopt an investment strategy. Investors should discuss their specific situation with their financial professional.
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