Despite an increase in volatility, stocks ended the second quarter with solid gains as the global economy continued to recover from the Covid pandemic. The bond market recovered some of its first quarter losses with a nice rebound during the second quarter. Strong corporate earnings across the board and rising consumer confidence continue to fuel stock gains, and consumers are on a spending binge after last year’s lockdown. While most economists expect this growth to slow down sometime in 2022, right now optimism abounds.
The one thing that is currently causing anxiety among investors is the threat of rising inflation. Inflation has been low for such a long time that many have forgotten what terrible economic damage can be caused by rapidly rising prices. The risk to the bond market is fairly obvious. Rising inflation leads to higher interest rates, which leads to lower bond prices. Bonds have benefited from forty years of dropping interest rates, but with rates effectively zero, we are likely to see rates move higher as economic conditions improve.
What is not quite as obvious is how inflation hurts stocks. Most calculations of equity valuation use discount rates as part of discounted cash flow models. In these models, the discount rate is the denominator in the equation. When this number gets lower, the fair valuation of stocks goes up. As rates move higher, these same models lead to lower fair market valuations. Very low interest rates and these valuation models are used by some in the industry to justify current market valuations. The problem is that these models tend to break down when interest rates are zero. Remember in third grade when you learned that you can’t divide anything by zero? The same thing applies to equity valuation models. No matter what interest rates are, higher rates lower equity valuations all the time. It’s no coincidence that stocks started rising when interest rates peaked and started dropping in 1981.
Now back to the questions posed above: Is inflation a threat? As we discussed in our year end letter, the Federal Reserve dropped its price stability (low inflation) mandate last year. It is obvious that the Fed wants to see some level of inflation. The tricky part is allowing inflation to rise while not allowing it to get out of control. Think back to the 1970’s, when neither stocks nor bonds could keep up with inflation. Equity valuations crashed as inflation and interest rates soared. High inflation with no growth (stagflation) was the result. As our economy has continued to evolve, this terrible mix of economic conditions is unlikely to repeat itself, but it is worth remembering that inflation is indeed a threat that needs to be managed.
Another threat to the current economic rebound is the Delta variant of Covid. Several U.S. states with low vaccination rates are at risk of new outbreaks. The markets are wary of new restrictions. We will be watching this closely.