Will Inflation Data Crush The S&P 500?
August’s inflation report was right on target, but the rest of the year could see higher numbers. So, even though the Fed will likely cut rates on September 16, those potentially higher inflation figures later in the year could impact the Fed’s future path. We’re concerned.
Why? In 2022, we saw firsthand how high inflation can impact the market. A series of rate hikes by the Fed, in response to rising prices, caused the S&P 500 to plunge by 25%, falling from 4,796 in January to 3,577 by October. High flyers like Nvidia lost more than 60%. Correct, $100 turning into $40 in Nvidia stock. This event serves as a recent example of the significant threat that inflation spikes pose to market stability. See – S&P 500 Index To Crash 8%? – for the index’s performance post-Fed’s disappointments in the recent past.
The point is, if inflation continues its upward trend, similar to what we’ve seen in recent months, it will likely prevent Jerome Powell’s Federal Reserve from cutting interest rates. The equity markets, particularly the S&P 500, will likely react negatively – potentially even convulsively, if the narrative of sticky inflation takes hold.
Persistent, sticky inflation is what scares us.
Image by Alexandra_Koch from Pixabay
How Much Damage – 10%, 40%?
Clearly, the Federal Reserve Chair Jerome Powell and the Fed view persistent, “sticky” inflation as a massive threat – and rightly so. The concern is rooted in historical precedent, look at the period from 1972 to 1974, when similar inflationary pressures contributed to an almost 50% drop in the S&P 500. In the current environment, AI, job cuts, and unemployment are top of every investor’s mind – add high inflation pressures – not 3-4%, but 7% or more, like we saw in 2022, and the Fed has no choice but to fight inflation hard with rapid and large increases.
Why Now? 3 Forces: Tariffs, Immigration, and Taxes
The current inflationary environment stems from three forces – tariffs, immigration, and taxes – that have created an uncomfortable environment for the S&P 500:
- Tariffs increase the prices of inexpensive goods imported from other countries, effectively removing cheap goods from the U.S. market.
- Immigration policy through mass deportation of undocumented immigrants may seem like sound policy, but it removes a source of inexpensive labor, making services more costly.
- Lower taxes, while generally desirable, increase the amount of money people have to spend on these now more expensive goods and services.
When you combine these three factors, it becomes more likely than not that prices will rise, creating persistent inflationary pressure.
For context on how severe market downturns can become, our dashboard – How Low Can Stocks Go During A Market Crash – captures how key stocks fared during and after the last seven market crashes, providing insight into potential recession scenarios. In such environments, positioning your portfolio is key – market timing is tricky – the High Quality (HQ) portfolio has outperformed its benchmark – a combination of S&P 500, midcap, and Russell, with >91% cumulative return since inception, and many investors choose to add downside protection to HQ. The point is simple – performance with preservation – as evident in HQ performance metrics.
Why High Inflation Devastates Growth Assets
The fundamental reason inflation hurts equity valuations is straightforward. The value of growth assets, especially equities, is derived primarily from future cash flows that are expected to – well grow – significantly over time. For example, cash flows for companies like Microsoft or Amazon are projected to grow by two to three times, or even more, in the next three to five years.
However, if inflation remains high and the Fed maintains or even raises interest rates to combat it, those future cash flows will be discounted at a higher rate, making them worth less in today’s terms. High rates mean, a dollar tomorrow is worth even less.
What else? Higher interest rates attract capital away from growth-oriented and riskier assets, redirecting it toward safer investments that offer a steady yield – that 5% yield on your savings account starts looking pretty good when the markets drop 10% in a week – right? For the S&P 500, this means money flows out of stocks and into bonds, creating downward pressure on valuations.
Many economists continue to view inflation as a significant risk to S&P 500 valuations. The risks are mounting, and the S&P 500 is vulnerable. If the inflation remains “sticky,” fundamentals won’t matter much to the investors. In fact, fundamentals take a back seat when investors get spooked by the outlook, and even great stocks can take a beating. To reduce stock-specific risk while getting exposure to upside, consider taking a look at the High-Quality portfolio, which has outperformed the S&P 500 and achieved returns greater than 91% since inception.
The Bottom Line
The S&P 500 is currently at a critical juncture. If the rest of the year’s inflation data confirms that price pressures are persistent, the market could face significant headwinds. The combination of policy-driven inflationary forces creates a perfect storm that could derail the bull market we have grown accustomed to.
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