Inflation—due primarily to rising food and energy prices—has returned as an investing concern.
But food and energy prices are traditionally volatile and not likely swayed much by interest rate moves.
Inflation's impact on stock returns is also difficult to predict.
While we wouldn't expect inflation to hamper growth significantly, it could certainly weigh on returns if it continues to be of primary concern to investors.
Six months ago, concerns about polar-opposites deflation and inflation jostled for investor attention. Now, with the US CPI ticking up and higher food (and other commodity) prices grabbing headlines, deflation fears have faded, leaving inflation in the spotlight.
The recent US CPI uptick is due in large part to increasing energy and food prices—both traditionally highly volatile—though core prices did accelerate from the previous month. Globally, headline and core CPI are both on the rise to varying degrees. Prices now have some worrying higher inflation could be a significant drag on growth.
In our view, higher inflation down the road is likely, but it's unlikely to be problematic this year. Excluding food and energy prices, US inflation is still historically tame. Now, the CPI is admittedly a bit wonky (as are most government-produced data), and some argue against focusing on core data for the very reason it eliminates food and energy—two frequently purchased categories of goods! It's a decent philosophical debate, but we still see the value of having a core metric. A common and effective tactic (when done right) for managing inflation is raising interest rates. But basing interest rate moves heavily on such volatile data as food and energy prices could mean an interest rate yo-yo—not really a terrific policy prescription. (Further, as we've written here recently, monetary policy doesn't necessarily have a huge impact on the primary drivers for food prices.)
Central banks globally have indicated a willingness to tighten as necessary—and many have already begun (China, India, Brazil, Sweden, and South Korea, etc.). But that's largely based on local and regional economic conditions. For example, take the UK versus China: British food and energy prices are indeed increasing and having some downstream effects on core inflation (as can happen). However, UK economic growth remains tepid, so for now, there seems little incentive to increase interest rates at the risk of choking already anemic growth. China, on the other hand, is experiencing high growth and high inflation—the response necessary there is undoubtedly different than what is appropriate for the UK.
So what does all of this mean for stocks? Probably not too much. Going back to 1980, there's practically zero relationship between changes in food prices and changes in stock prices. And, stocks have risen in periods of rising inflation. It's not necessarily rising inflation that is bad, but the central bank reaction that could be problematic, which is tricky to predict—tighten too much too quickly and you could choke growth and ding stock prices. Tighten too slowly and stock prices may benefit initially, but inflation could get out of hand and subsequently drag on growth and stocks. Keep in mind, too, that while runaway inflation (which we don't foresee at this point) isn't a terrific scenario for stocks, it doesn't necessarily make equally liquid alternatives automatically more compelling. (Cash loses buying power as inflation increases; bond prices drop as inflation typically translates into higher interest rates.)
Ultimately, we expect inflation to pick up as the year wanes on, but not to levels impeding economic growth or necessitating some sharp central bank response (though individual nations may have to react more strongly based on local conditions). While we don't anticipate inflation being problematic, the fear of it could certainly be one factor weighing on some investors' minds—contributing to muted equity index returns.