It’s been two years since inflation hit its covid-fueled high of 9%, an ugly rollercoaster ride not seen in 40 years. In response to the runaway inflation, the Fed jacked its key interest rate from 0 to 5.5% – its highest level since 2006. The fallout in 2022 was heavy, with stocks suffering their worst losses since the 2008 financial crisis and bonds having their worst year ever. 

Despite seemingly constant recession calls by Wall Street last year, investors were smart not to swerve to avoid the recession that never showed. Stocks rallied by 20+% and bonds had positive returns as inflation marched back downward towards pre-pandemic levels. 

Source: https://tradingeconomics.com/united-states/inflation-cpi

But after reaching new all-time highs for the first time in two years, stocks have stubbed their toes since March as inflation has slowed its decline. Meanwhile, 10-year interest rates have spiked to their highest level since last October putting additional pressure on stocks. With stocks off their all-time highs, investors might ask which is the greater evil – rising inflation or interest rates?

(Quick sidenote – declining inflation is the price of goods going up at a slower pace. Deflation is the price of goods actually going down. Investors want slow, moderate inflation. Deflation feels good for our pocketbooks but is bad for the economy and stocks.)

Hitting Where It Hurts

Rising interest rates slow the economy by increasing the cost of borrowing (and spending) for individuals and businesses. Meanwhile, inflation can harm the economy by reducing the spending power of consumers. Higher prices mean consumers can buy fewer goods with the same amount of money. Which factor is a bigger drag on stocks? 

US Stock Market Average Returns: 1928-2021

Data: NYU (S&P 500, returns annualized); Rates: 10 year treasuries

Inflation Stings

Surprisingly, the difference in stock market performance over the past century has been negligible whether rates are rising or falling. The same cannot be said when looking at the drastic difference in stock returns between rising and falling inflation. And as you can see from the table, rising inflation has historically been much more harmful to stocks than rising rates.

Optimistic News

Since the summer of 2022, inflation has fallen from 9.1% to 3.5%. It’s no surprise that the S&P 500 index is up 30% during that same timeframe, supporting the historical data that falling inflation is a considerable tailwind for stocks. 

Silver Lining

Recent months have brought frustration among investors disappointed that inflation isn’t falling faster. The data suggests that investors should focus on the direction of inflation, rather than its pace.

While inflation’s direction has been mixed in recent months, investors can take solace that strong labor markets, consumer spending, and corporate earnings growth have also accompanied sticky inflation. Finally, investors should remember that slaying the inflation dragon is a lot like the last leg of running the Boston Marathon – it’s more painful and slower than you wished.

Castle Quote: “Learn every day, but especially from the experiences of others. It’s cheaper!” 

– Jack Bogle