As markets continue to set record highs, so does persistently high inflation. If you recall, the Federal Reserve initially expected inflation to be transitory. Unfortunately, that hasn’t panned out as U.S. inflation continues to increase and is running at a 13-year high at 5.4%. Some of this increase can be attributed to the pandemic lasting longer than expected, but the question is whether this spike is temporary or a long-term issue.
By now, we have all read the stories about ships stuck at ports, empty car dealerships because of chip shortages, and the stratospheric rise in oil and natural gas prices. Much of the blame has been attributed to the pandemic and its disruption on the global supply chain. There is truth to this attribution, but some analysts also point to the $10 trillion-plus of stimulus injected into the global economy with near-zero interest rates as the recipe for high inflation.
The hope is that inflation starts to subside next year as things get closer to “normal” and supply chain bottlenecks subside. Whether this will happen remains to be seen.
Consumer Sentiment
Inflation in and of itself is not necessarily a death blow for the global economy. But based on the uncertainty of how long it will persist, the question is whether consumers and businesses will start to change their behavior.
In my opinion, this behavioral change is the biggest risk right now. The psychological aspect cannot be understated. If consumer sentiment shifts, that alone can weaken the global economy. Consumer spending accounts for an eye-opening two-thirds of the U.S. economy, and any sudden change in spending habits can bring the global economy to a screeching halt and ultimately into a recession.
It is important to note that much of what we consume in the U.S. is produced abroad, so if we consume less, it will have a domino effect on the rest of the world.
Supply Chain
Corporations such as FedEx, Unilever, and Adidas warn that supply chain issues and inflationary pressures will last far longer than policymakers anticipate. These warnings could be a cautionary tone to lower earnings expectations.
The truth is the longer consumers and businesses think inflation will remain elevated, the more likely they will react. That reaction generally means higher prices and lower consumer spending, which can lead to lower corporate profits and turn into corporate layoffs.
Source: Statista.
As seen above, supply chain disruptions are on the rise again. The assumption is that inflation is transitory and that these disruptions will subside. Because of that assumption, there hasn’t been a big shift in consumer or business spending.
If the disruptions continue to remain stubbornly high over the next few quarters, sentiment is likely to change, and that is where things could get tricky. This trend needs to be closely monitored over the first two quarters of 2022.
Commodity Prices
The supply chain bottleneck over the past year has caused commodity prices to increase by eye-popping percentages.
These sharp increases in commodity prices have led workers to demand higher wages to help offset higher costs. This means corporations either increase prices on their goods and services or watch their profits shrink. Neither outcome is positive, especially over the long run.
Rising inflation is easier to overcome in a thriving economy as both consumers and businesses can absorb increased prices. While the global economy has markedly improved, many countries are not back to their pre-pandemic levels.
Stock Market
The stock market, specifically the S&P 500, has been extremely resilient. Since last April, there has been little to stop its upward trajectory. The concern is that stock market valuations, which are already stretched, will be derailed by persistently high inflation and serve as the catalyst for a market correction.
A common misconception is that rising inflation equates to a weaker economy and stock market. While many variables are at play, inflation alone isn’t necessarily a bad omen for either the economy or the stock market. Rising inflation tends to have a bigger impact on the bond market, making it vital to understand the types of bonds you own.
Source: DFA.
While inflation has been subdued over the last two decades, the S&P 500 has experienced some of its best returns in years where it was highest!
It is important to remember that the stock market is not necessarily a barometer of a healthy economy anymore. You could make the argument that a thriving stock market makes consumers and businesses feel more confident to spend. However, according to calculations conducted by New York University, more than 80% of all U.S. stocks are owned by the richest 10% of U.S. households. So, while a higher stock market has some positive impact on the economy, the correlation tends to be overstated.
Also, like most things lately, the inflation debate has become highly politicized. Generally, things usually aren’t as good or bad as they seem—they tend to be somewhere in the middle. As we always say at our financial planning firm, ignore the headlines and don’t make rash portfolio decisions based on them.
Discuss your situation with a fee-only financial advisor.
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