Inflation hits 7%: what impact will this have on the outlook for the S&P 500?
With inflation at its highest in decades, bonds are not a great place to hide. Stocks or real assets, such as real estate, seem like more appropriate investments at times like these. Individual stocks can still suffer from inflation, for example if consumers spend less on certain goods or if higher input costs cannot be passed on to consumers. In this article, we’ll look at the link between inflation and stock market returns and what that means for investing in the S&P 500 (SPY).
What is the impact of inflation on the stock market as a whole?
Inflation measures the change in prices of consumer goods, services, etc., and thus maps the loss in value of money. Inflation has generally been relatively benign over the past two decades as the Fed has been able to keep price changes more or less in line with its 2% target. In 2021, however, inflation accelerated massively, reaching as high as 7% in December, the highest level in over 30 years. This was caused by several contributing factors, among them rising energy prices, rising transportation costs and increasing wage pressure.
With inflation at levels well above 2%, buying bonds offering yields of 1% to 2% seems like a pretty bad idea, as net losses in real terms are more or less guaranteed.
However, equities have a better chance of resisting inflation. Since stocks represent ownership of companies and their respective assets (brand value, factories, inventory, equipment, machinery, real estate, etc.), they are often seen as a hedge against inflation. And they, in fact, tend to outperform bonds and other fixed rate assets during periods of high inflation. Not only do the assets that companies own increase in value, but companies can also, ideally, increase their profits.
For example, let’s say a company makes a phone for $250 and sells it for $400, making a profit of $150. If 10% inflation causes the business to incur a 10% increase in expenses (materials, labor, etc.), the expenses jump to $275. If the company also increases the price of its phone by 10%, in line with general inflation, the selling price jumps to $440. Profit in this simple scenario jumps to $165, 10% higher than before inflation played a role. In real terms, the company’s profit therefore remained stable: the company neither benefited nor suffered from inflation.
Of course, not all companies are able to increase input costs. This example therefore does not apply to all companies on the market. On the other hand, some companies that have locked in input costs may still be able to push through price increases, thereby increasing their profit margins.
Stocks therefore offer some protection against inflation, but some studies indicate that stocks do not provide perfect protection against inflation overall. Of course, there are many other contributing factors that play a role in stock returns, such as real GDP growth (which is high right now), Fed policy, and more.
Are stocks good during inflation?
Stocks tend to offer some inflation protection and are therefore a better choice than bonds, cash, etc. in times of inflation. With bonds, there is a strong chance of positive real returns, whereas holding cash that loses 3%, 5%, or 7% of its value every year offers no chance of positive returns.
However, not all stocks perform equally well in times of inflation. Some industries offer well above average inflation protection, such as energy (XLE), mining (XME), real estate (VNQ), making them particularly suited to an investment environment where the inflation is at a high level. Commodity producers benefit from higher commodity prices, leading to higher profits. The real estate held by REITs appreciates while their debt swells, making them winners in an inflationary environment. Similarly, other owners of real assets that have already been paid for, such as infrastructure companies (pipelines, terminals, power plants, etc.) also benefit from the same principle: their assets appreciate in value, while their debt generally important swells. a way.
Being in stocks in these industries therefore offers above-average inflation protection, compared to other stocks that cannot pass on higher costs as easily (retail, foodservice, etc.).
What is inflation doing to the S&P 500?
The S&P 500 Index represents ownership of a wide range of US stocks. In general, the principles that make equities a better choice in times of inflation also apply to this index, although it should be noted that the impact of inflation is not the same for all components. of the S&P 500.
There is a notable distinction between how value stocks (VTV) and growth stocks (VUG) tend to perform in times of high inflation. Value stocks, with low growth and high current cash flows, generate the majority of their future earnings for the foreseeable future. Growth stocks, with strong growth but little or no current earnings, will generate the majority of their future earnings many years from now. Higher inflation forces central banks to act, usually by raising interest rates or withdrawing monetary stimulus. This results in higher discount rates, which naturally have a bigger impact on growth stocks because their earnings are further in the future. Thus, value stocks generally outperform in times of rising inflation and rising interest rates, while growth stocks perform better in times of falling inflation when interest rates are low or falling.
The S&P 500 contains both value and growth stocks, although it has a relatively high allocation to industries such as technology (XLK) or communication services (FCOM), which are generally high growth. The current S&P 500 weightings look like this:
We see that industries with above-average inflation protection, such as energy, materials and real estate, make up small portions of the index, at less than 3% each, respectively. On the other hand, the high-growth technology industry accounts for more than a quarter of the overall index.
It could therefore be argued that the S&P 500, due to its high growth allocation, offers somewhat weaker inflation protection compared to a more equally weighted equity portfolio. Nonetheless, the S&P 500 will provide superior inflation protection and long-term performance relative to most non-equity assets, including bonds/fixed income and cash.
Is SPY a good choice during inflation?
If one wants to invest purely to hedge inflation or seek to maximize returns in a scenario where inflation remains high or rises further, SPY is not the best choice. In this scenario, a higher allocation to inflation beneficiaries such as energy or real estate would make sense. It could also be argued that a higher weighting of names in financials could be a viable choice, as Fed interest rate hikes will lead to higher net interest margins for most banks.
However, most investors don’t want to position their portfolios for pure inflationary play. Given that the SPY still offers reasonable inflation protection compared to non-equity alternatives, while offering great diversification that helps weather different types of macro crises, the SPY does not appear to be a bad investment choice. investment.
For those looking for particularly strong inflation protection, SPY isn’t ideal, but it still seems like a very reasonable investment choice for someone looking for broad exposure to US equities. SPY can be expected to perform well over the long term, and investors should consider the ETF’s very low fees an advantage over many of the smaller, more specialized ETFs which typically have higher fees. students.
Is the SPY ETF a buy, sell or hold?
The SP 500 index is trading at around 19.5 times this year’s expected net profit, based on expected EPS of $225, per Yardeni. It’s not a low valuation, but it’s not terribly expensive either. The US economy is recovering well from the pandemic, and with economic growth reaching a surprisingly high level in the fourth quarter of 2021, it seems possible that we will see further upward revisions to current EPS estimates for the S&P 500. ‘SPY is also offering a dividend yield of 1.3% at the moment – arguably at the low end of the historic range.
The economic outlook is solid and valuations are not extremely high, but on the other hand, there is a lot of uncertainty about where the market is headed in the weeks and months ahead. Interest rate concerns have led to significant volatility in the S&P 500 and individual stocks, and it might be wise to wait to see how things play out before entering the SPY.
I believe investors who hold SPY will do reasonably well in the long run, but the broad index isn’t cheap enough to make SPY an outright buy.