As witnessed by the market’s turbulence so far this year, stock valuations are adjusting to a shifting landscape that includes rising inflation and a much more challenging business environment. The question on every investor’s mind is what to expect over the next several months.

In an Inflationary Environment, What Really Drives Stocks?

A look back at periods of peak inflation in the U.S. over the last century reveals the complexity of this question. As the chart below shows, of the sixteen calendar years of highest inflation, eight were positive for the S&P 500 Index and eight were negative. What can we learn from this? 

A measure of inflation alone reveals little about the near-term direction of stocks; rather, a well-informed outlook must be founded on an understanding of the drivers of inflation and the impact of changing governmental and industrial policies on the economy. 

S&P 500 Total Return During 16 Years of Highest Inflation: 1922-2021

Examples from the 1970s

The period from 1973 to 1981 proves this point, one in which the flawed monetary policy of previous years (interest rates were kept too low to curb GDP growth¹) provided tinder for a global energy crisis and ballooning U.S. government spending on the Vietnam War. This resulted in a firestorm of inflation, a stagnant economy, and rampant unemployment—“stagflation.” 

The chart shows that, as always, swings in stock prices were driven by changing expectations for the future. A few examples:

• The OPEC embargo of 1973 constrained the global supply of petroleum oil, driving prices up across industries, with stocks suffering as a result.
  
• The end of the Vietnam War in 1975 carried the hope that government spending—a key driver of inflation—would be reined in. This may have contributed to the rally in the S&P 500 that year.
  
• The dramatic increase in the federal funds rate in 1979, led by Federal Reserve Chairman Paul Volcker, may have initially boosted confidence in the direction of the economy (and stock prices), but eventually ushered in recessions in the early 1980s. Volcker’s relentless interest rate policy eventually “broke the back” of inflation, returning the economy to sound footing.
  

Similar inflationary environments. . .different stock market results based on the shifting policies of governments and industries. . .

The Take-away for Clients 

The unpredictable nature of stock returns during times of peak inflation points to a basic principle of investing: Rather than giving in to impulses to try to time the market, it’s better to stick to a well-crafted plan based on their personal financial goals, time horizon, and risk tolerance. In times like ours, when uncertainty can feel overwhelming, that message can make all the difference.