Friday's Market Minute: Inflation Has Been Good for the Stock Market

Higher inflation next year may hinder the U.S. economy to some extent, but there will still be above-average economic growth considering that the labor market has yet to reach full employment. With above-average economic growth and the low cost of financial capital, we should expect overalls gains for equities, but it probably won’t be smooth sailing like 2021 has been so far.

There is no doubt that strains in global supply chains and the spike in energy prices could have longer-lasting effects on inflation than previously expected. Based on the latest figures, CPI is running at a 6.2% annual pace, the highest rate in over 30 years. In the past 12 months, consumer price inflation has been led by a 59.1% increase in energy services (i.e., electricity and natural gas), a 49.5% increase in gasoline, and a 26.4% increase in used car prices. Despite these high year-over-year figures in energy and autos, supply chain blockages that have been hampering many parts of the economy should begin to clear up over the course of next year.

With rising inflation and artificially low nominal yields, falling real interest rates have prompted investors to take greater risks investing in equities and alternative assets as the search for yield in low-risk assets proves more difficult to come by. Right now, the real yield on the U.S. Treasury note is around a negative 4.5%, and one has to go back to the 1970s to find negative real Treasury yields around this level. According to recent statements made by the European Central Bank, this has left parts of the property, corporate debt, and crypto-asset markets “increasingly susceptible to corrections.”

In their effort to create inflation for over a decade now, the Fed seems to have succeeded. After all, deflationary forces are a much bigger policy challenge. Inflation creates an intertemporal propensity to bring forward consumption and investment because of the higher economic cost of saving. Deflation is a much more difficult animal to tame because if one expects prices to fall in the future, it leads to postponing consumption and lessens future return on invested capital. With the tapering of purchases coming on, there is a real concern brewing over what is going to happen to the Fed's policy rate of interest. Right now, the market is predicting only one increase in the Fed funds rate in 2022, and analysts estimate that the increase will come anytime from June to September. With U.S. government borrowing that could reach as high as $2.0 trillion in 2022, a Fed slowing its pace of asset purchases to an eventual end, and at least one rate hike, perhaps equity investors should expect some turbulence to come.

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