Inflation Still a Distant Catalyst for a Decline in Equities

With all the talk about inflation and equities and the potential rise in rates, you can’t blame equity investors for being a little cautious about any continuation in the S&P 500 continuing to hit new all-time records. At some point, the music is going to stop, but it’s not when the Fed announces the end of its accomodative policies – someone, somewhere will start selling before then.

The question on everyone’s mind is how high does inflation have to get before expected equity returns suffer? Valuations notwithstanding – and valuations on US equities look stretched by many measures, we can still have solid equity returns over the next 12 months at today’s inflation rate. In fact, even though returns drop off once inflation rises above 2%, the average annual returns when the inflation rate  is between 2-6%, is still a solid 8.5%. It’s only when the average inflation rate surpasses 6% that not only do the returns on the S&P 500 decline, the real returns (Returns-inflation) become negative.

The returns the S&P 500 have generated over the last 10 years have been unprecedented. Even with all the talk about housing prices increasing by double digits since the pandemic started, an investment in the S&P 500 would have been a clear winner. It’s no wonder Millennialls think buying a house is not a good investment – as I mentioned in a previous post – no matter, they are still driving the demand for single family homes in the suburbs.

So what will happen when the Fed does finally start raising rates – which is not expected until late 2022 or early 2023? Well, after an initial pullback, stocks tend to keep going up. In fact, rarely does the S&P 500 have a negative return in the 12 months after the Fed starts tightening. In 2015, the S&P500 actually returned almost 30% over the next 2 years as the Fed was raising rates.

Bottom line is that I’m cautious about the S&P 500 right now but believe there are still returns to be made (Call it greed, I guess – although I am reducing overall equity exposure in some of the more conservative portfolios I manage) are ) . I’ve shifted my positions to reduce exposure to many of the stocks that drove a majority of the indexes returns over the recent couple of years (I.e. Technology) and allocated more to the smaller companies within the index and sectors that especially benefit from economic growth early in the expansion cycle. When the Fed starts to raise rates, I’ll keep an eye out for opportunities to reduce overall exposure, but a rotation to value and defensive stocks should result in a less painful pullback than that of the broader index. It’s time for some tactical asset allocation.