Inflation and the Impact on the Market
You are going to continue to see many headlines talking about inflation and its potential negative impact on the economy and markets. It is true that hyperinflation is massively destructive; that certainly was the case in the 1980s. It is also true that deflation or stagnation is also destructive. There have been periods in the past where the economy endured this condition as well.
More normalized inflation between 2% and 4% is still a higher inflation rate than we have seen over the past couple years. For that reason, the media has been talking about increasing inflation as an automatic negative. In actuality, that’s really not the case. Normalized inflation is actually healthy for both the stock and bond market.
At Destination Wealth Management we are continually assessing this type of information as we make judgments about investments. We recently conducted an analysis about the impact of inflation on stock and equity assets utilizing three different inflation forecasts. These forecasts show how assets have been impacted by inflation statistics and might be surprising to you.
The bottom line is that inflation that is more normalized, between 2% and 4%, is not destructive to the stock and bond market.
At DWM we will continue to analyze information as it becomes available and will adjust portfolios accordingly.
If you are curious, here’s how we conducted the analysis examining inflation and its asset impact.
We utilized the following sources:
- Bloomberg for annual total returns going back to 1976 for the S&P 500 Index.
- Bloomberg for annual total returns going back to 1976 for the Barclays Aggregate Bond Index.
- Bureau of Labor Statistics for Inflation data (US CPI-U) for all Urban Consumers going back to 1976. For CPI, we used Dec CPI y/y change.
We adjusted the S&P 500 and Barclays Aggregate Index returns for inflation. The formula we used for inflation adjusted return for example is (1+ 2020 S&P total return)/(1+ 2020 inflation)-1 (source: DWM calculation (1+ S&P 500 total return)/(1+ inflation)-1) and (1+2020 AGG total return)/(1+ 2020 inflation)-1 (source: DWM calculation (1+AGG total return)/(1+ inflation)-1).
The results were sorted into three categories based on 1) < 2% inflation, 2) 2%-4% inflation and 3) >4% inflation. We then calculated the average of the inflation adjusted S&P 500 and AGG return to reproduce the graphic inside an excel sheet.
S&P 500 Index: The S&P 500 Index, or the Standard & Poor's 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index. The index is widely regarded as the best gauge of large-cap U.S. equities.
Barclays US Aggregate Bond: The Barclays US Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, Mortgage-backed bonds, Corporate bonds, and a small amount of foreign bonds traded in U.S. Barclays US Aggregate Bond Index is an intermediate term index.
Destination Wealth Management constructs portfolios and investment objectives based on asset allocation principles coupled with tactical adjustments. The firm employs research analysts with significant experience to conduct asset and economic research. DWM allocation philosophy will adjust based on market conditions and economic environment. Allocations are not static and will adjust as needed. These strategies may not be suitable for all investors. For additional information and disclosures, please refer to Adviser’s Form ADV Part 2A.