Inflation nation: How US inflation is impacting the global stock market

As US inflation surges to its highest rate in decades, it’s likely to spook the global stock market with investors likely to go on the hunt for winners and losers.

At 6.8%, US inflation is more than triple the Federal Reserve’s 2% target. At an almost 40-year-high, soaring inflation has been driven by a range of factors, from supply chain disruptions and extraordinarily strong demand, to the Federal Reserve’s response to the COVID-19 pandemic.

To rescue the economy, the Federal Reserve added more than USD$4 trillion to its balance sheet through its open-ended quantitative easing program, while the US government unleashed more than USD$5 trillion in fiscal stimulus.

As a result, some pundits had expected the inflation rate to already be north of 7%. In the face of rising inflation, the Federal Reserve may be forced to step up the pace of tightening policy. This could unsettle markets, especially with the Federal Reserve also likely to raise its interest rate outlook.

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How is it affecting the stock market?

Despite inflation fears, the S&P 500 rose to a record close recently, in part because some investors were anticipating an even hotter inflation reading than economists. If the market has already priced in higher inflation, this will ease its impact.

Will inflation continue to rise to 7% and beyond? Perhaps not. We think earnings forecasts for US stocks are too low and they should swell next year. As we move into 2022, pressures could ease, with the inflation rate dropping back closer to 4 or 5%.

While the exact inflation rate in 2022 is open to debate, it’s clear that inflation is here to stay. So is that good or bad for the market? That depends on where you put your funds.

High inflation and the stock market

Higher inflation is generally viewed as bad for stock prices, because it increases borrowing costs and increases the input costs of materials and labour.

It’s a vicious circle: as input prices rise, consumers cannot afford to purchase as many goods as before, which sees revenues and profits decline. This puts downward pressure on stock prices and the economy slows, until it eventually reaches an equilibrium.

That said, the impact of inflation is not consistent across the board. Commodities such as oil and tangible assets such as real estate are two sectors which tend to fare better than others. Cryptoassets are also considered a good hedge against inflation. Unsurprisingly, these are the three best-performing assets classes this year.

One of the key impacts of high inflation is reduced expectations of earnings growth. As a rule of thumb, growth stocks perform better during low inflation, while value stocks perform during high inflation.

When inflation is on the upswing, the price of income-oriented or high-dividend-paying growth stocks generally declines. Rising inflation hurts their future earnings expectations.

To further complicate matters, inflation during boom times tends to affect things differently than inflation in bad times.

Stocks react much more negatively to inflation when the economy is contracting. That makes sense when you consider that a contracting economy tends to see profits and revenues decline. When the economy is growing, profits are higher – as they are now – and the economy is better able to withstand higher inflation.

So, what’s happening now?

Right now, the US economy is still growing as it emerges from the 2020 recession. Although, at 2% in the third quarter of 2021, it’s the slowest gain of the pandemic-era recovery.

Despite recent turmoil, US stocks are headed for a rare third-straight year of double-digit returns. To continue this run next year would be rare, given we have only seen four straight years of double-digit returns once before in the last 50 years.

However, we anticipate the US markets could get close to a fourth consecutive year of double-digit returns in 2022. Current consensus earnings growth expectations seem too low right now, with Gross Domestic Product growth still strong and companies demonstrating they can offset rising cost pressures and keep profit margins high.

This is a critical point, because inflation tends to affect corporate profits due to higher costs. Through Q3 2021, we saw a lot of big corporates navigate this well as they offset costs. Take Tesla, for example, costs increased through supply chain issues, but most of its vehicle prices increased over that time.

What does the future hold?

Right now we’re likely near the inflation peak, as supply chains adjust. As we move into 2022, we believe inflation fears will begin to ease. Forecasts are for 4.6% inflation this year and a still high, but lower, 4.2% next year.

New COVID-19 strains and supply chain uncertainty may continue to make themselves felt in 2022, so it remains to be seen how high US inflation will remain. This could spook investors yet, with a growing economy and healthy fundamentals, it seems the global stock market is well-placed to weather the inflation storm.

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