It has been hard to ignore inflation recently, but the stock market is doing so, marching higher even while the cost of living soars.
It’s a movie that screened earlier this year, when investors saw early evidence that inflation was jumping, and the market barely flinched. The May 12 release of the consumer-price index showed a surprisingly large gain of more than 4% year over year for April. While the stock market did fall that day, the losses didn’t last.
The S&P 500 rose the next day and posted an 11.6% gain from May 12 through early September, when it reached a fresh record high. Investors’ reasoning seems to have been that inflation was “transitory,” as Federal Reserve Chairman Jerome Powell has said, and that the pace of price increases in the economy just represented a rebound from 2020, when lockdowns were devastating demand.
Prices were normalizing, according to the conventional view. The rate of inflation was expected to decline.
That hasn’t happened yet. The CPI for October, released Nov. 10, showed a higher-than-expected 6.2% annual increase. Not only are prices still being compared with the depressed levels seen in the fall of 2020, but problems in the supply chain are increasing companies’ costs, forcing them to raise prices. Expectations for long-term inflation are now at 2.73%, a level not seen since before the 2008-2009 financial crisis, according to data from the St. Louis Fed.
Yet stocks have continued to rise. Since the inflation data came out on Nov. 10, the S&P 500 has risen 0.7%, continuing a strong run for more than a month.
One reason is that the supply-chain problems are easing and inflation is still expected to cool down. The cost of leasing shipping containers has fallen precipitously since August, indicating that there is more capacity in the global freight system, relative to demand. The price of steel, a critical raw material for many manufacturers, has fallen more than 3% since the end of August.
Those declining costs, coupled with rising prices for goods sold, have helped corporations to earn more than expected. The third-quarter earnings-reporting season is drawing to a close, and aggregated profits for companies in the S&P 500 are about 10% higher than expected.
The second reason for the market’s rally is that bond yields remain stubbornly low despite inflation. The yield on 10-year Treasury debt is still at 1.6%, below its 2021 peak of 1.75%. And the real yield—the nominal figure minus the expected rate of inflation—is negative 1.1%. Historically, Treasury yields tend to sit above the inflation rate.
The lower the real yield on bonds, the more reason investors have to buy stocks, with their higher risks and greater potential returns. That has sent the aggregate price of the stocks in the S&P 500 up to 21.4 times the total per-share earnings expected for those companies over the next 12 months. The figure was 20.2 times in early October, after a market pullback.
Capital Economics summed up why the stock market has powered ahead. “US equities have shrugged off this year’s surge in inflation, probably because it has not coincided with either a rise in the real yields of Treasuries or weakness in corporate earnings,” wrote Oliver Allen, the firm’s markets economist.
The party for investors is still happening, but risks are now mounting up. Bond yields are likely to rise from here–many on Wall Street don’t see their historically low levels as sustainable— and the Fed could raise interest rates to combat the inflation. That would dent economic growth.
Stocks may be the best game in town today, but that may be less true tomorrow.