If you follow markets news, you've probably seen a few hundred headlines this year akin to: "Stocks slide as red-hot inflation weighs on investors."
At first glance, it's a perfectly reasonable thesis. Inflation rates are still at 40-year highs and the Fed is serious about raising rates to fight them. Neither is particularly good for business. Plus, it's only natural to seek out a quick and easy-to-digest explanation for big market moves (guilty as charged).
But, like most things in life, inflation's impact on markets is not that simple.
Although investors may have a gut reaction to sell every time new, alarming inflation data gets announced, historically, high inflation alone has not been directly responsible for market downturns.
To borrow the words of the late market luminary Jack Bogle, founder of Vanguard, "the daily machinations of the stock market are like a tale told by an idiot, full of sound and fury, signifying nothing."
The big picture: Inflation and US markets have a complicated relationship, and like most relationships, long-term stability is key. Investors hate surprises. They can work with elevated inflation but they don't like sudden, sharp increases in those rates.
We've known this since at least 1983. That's when Martin Feldstein, who advised multiple presidents and served as the president of the National Bureau of Economic Research for three decades, determined that if we want to relate inflation to stock prices it's crucial to distinguish between high but steady inflation and the expectation that prices could rise more sharply in the future.
Even when prices are rising steadily, investors can cope, sending shares up in proportion to inflation, he said. It's when economists sound the alarm bells about future price spikes that send investors heading for the exit.
Heightened inflation plays an important role in market returns, said Michael Batnick with Ritholtz Wealth Management.
"There's a level at which inflation starts to become a bigger part of the picture, but even more important than that is whether inflation is rising or falling," he wrote. Inflation at 6% tells you that inflation is high, he said, "but 6% down from 8% tells you that inflation is high but falling, which the market likes."
A recent analysis of market performance by the Leuthold Group found that when inflation is high, stocks tend to perform very well right after the rate peaks. When the rate of inflation is 8% or above (the annual inflation rate in the United States is currently 8.6%), a deceleration in inflation is usually coupled with a full year of stock gains, the study found.
Equities can also provide a pretty decent hedge against inflation in the long run.
"We believe stocks are one of the best places to be in a rising inflation world," wrote Tony DeSpirito, managing director at BlackRock, in a recent note. BlackRock looked at stock performance dating back to 1920 and found that as long as inflation doesn't cross 10%, equities continue to perform relatively well.
But he added that rising inflation and rates is also stoking higher volatility in stocks, and investing is getting tricker.
Investors can prepare their portfolios to better weather high rates of inflation. Value stocks, with more stable near-term cash flows, have the upper hand on growth stocks when prices are surging, said DeSpirito.
The S&P 500 Growth Index, which tracks stocks that have the best three-year growth in revenue and earnings per share, has fallen nearly 15% in the past year. The S&P 500 Value Index, which tracks stocks with the best valuations, dropped by just 4.8% over the same period. The S&P 500 has lost about 10% year-over-year.
The energy sector also tends to outperform the rest of the market during periods of high inflation. The sector had an annualized return of 14% between 1968 and 1981 and will likely have an outsized impact on earnings estimates this quarter, according to the Wells Fargo Investment Institute. Energy earnings in the S&P 500 are expected to grow by nearly 205% this quarter while forecasters say the rest of the S&P 500 will decline by 2%.
Healthcare is also often a bright spot, as my CNN Business colleague Paul R. La Monica recently wrote.
But the best hedge against inflation is patience.
Between 1966 and 1981, a period encompassing much of the stagflation era, investors in the US stock market lost more than 35% after adjusting for inflation, according to analysis by Ben Carlson, also with Ritholtz Wealth Management.
Those who stuck it out, however, ended up on top. Between 1966 and 1999, nominal annual returns were 12.3% against a 5% annual inflation rate, leaving investors with 7.3% real returns over 34 years.
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