The last two years have been the perfect storm for inflation. Not only have these trends not let up, but they have affected interest rates, Fed policy, consumer spending, and corporate profits — helping to push the market back to bearish. So, how can long-term investors maintain perspective in this challenging environment?
Last week’s data shows that the Consumer Price Index, a common measure of inflation, accelerated again in May after briefly slowing in April. Compared to the previous year, consumer prices rose 8.6%, the fastest growth rate since December 1981. Even “core” CPI, which measures the underlying inflationary trend, climbed 6%. — contributing to the S&P 500 reaching bear market levels.
Chart: Inflation has worsened in recent months
Sources: Clearnomics, Bureau of Labor Statistics
It’s helpful to review how we got here. Beginning in 2021, global supply chain problems worsened due to strong consumer and business demand as the economy recovered. The war in Ukraine and other factors then led to steep increases in energy and food prices, impacting consumer pocketbooks. The competitive labor market has meant shortages of workers and higher wages, eating into businesses’ profit margins. For these reasons, inflation remains a focus for investors.
As a result, investors are worried the Fed will be forced to “induce” a recession to control inflation. This is exactly what the central bank did under Paul Volcker in response to the stagflation of the late 1970s and early 1980s. By tightening monetary policy, the Fed was able to control runaway inflation at the expense of economic growth at the time. Fortunately, it worked, and set the stage for subsequent growth over the 1980s and 1990s.
While the parallel to the Volcker era is instructive, there are important differences today. Inflation was much worse throughout the 1970s, with multiple periods of double-digit price gains over the decade. Not only have all economists and central bankers studied that period extensively, but the Fed is already beginning to tighten more quickly, albeit with an unfortunate delay. In contrast, the Volcker Fed didn’t start to tighten until 1979 after annualized inflation had already averaged 8.2% for nearly seven years.
Also, unlike the 1970s, underlying demand in the economy is still fundamentally strong, and unemployment is near historic lows. Ironically, this is one reason inflation is a problem in the first place. So, while a technical recession is always possible as the Fed tightens, we are not beginning with a period of economic stagnation nor a runaway inflationary spiral.
What does this all mean? To no one’s surprise, how markets, consumers and businesses do from here depends heavily on the path of inflation. While the Fed is trying to not contribute to the problem, the underlying issues related to supply chains, manufacturing, and energy are outside of their control. If these issues are resolved and the largest shocks to prices are behind us, then many measures of inflation could slowly begin to turn. Either way, markets are arguably positioned for the worst-case scenario, and the Fed is already stepping on the brake.
Thus, investors should consider staying disciplined rather than trying to guess the exact direction of inflation. While this is the first inflationary period in four decades, investors have faced numerous market challenges over the past several years. Staying invested in diversified portfolios has been one common approach throughout these periods to keep working towards financial goals.
Chart: Markets have fallen this year but have done very well over longer timeframes
Sources: Clearnomics, Standard & Poor’s
And while the stock market is in the red for the year, zooming out paints a different picture. Through Friday, the S&P 500 has gained 56% over the past three years, 15% since the pre-pandemic peak in early 2020, and 74% from the pandemic bottom. While investors may prefer a smooth ride, with steady gains day after day, this is unfortunately not how the market operates. Instead, the price of long-term gains is the ability to stomach short-term declines.
None of this discussion is meant to ignore or downplay the challenges that lie ahead for markets. However, many of these challenges are widely understood by investors who have been grappling with them for months. Investing isn’t always easy, and in today’s market environment, it’s important for investors to understand market behavior and consider the big picture.
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