Inflation is likely to ease in the near future and when it does, the stock market should perform handsomely thereafter, judging from history.
The Consumer Price Index rose 6.8% year-over-year in December, its highest reading since 1982. Driving that inflation is a surge in demand compared with last year’s lockdown-laden economy and a limited supply of products and labor, which causes companies’ costs to rise.
But gravity will bring the inflation rate down. Long-term expectations for average annual inflation are below 3%, according to St. Louis Fed data. Additionally, the Federal Reserve has made clear that it is rapidly ending its pandemic-era monetary support program and is now projected to raise interest rates three times in 2022 to combat inflation.
If U.S. inflation is nearing its peak for this economic expansion—even if the December reading wasn’t the exact peak—the stock market should perform well. On average, the S&P 500 sees a 13.2% return in the 12 months following peak inflation since 1951, according to data from The Leuthold Group. The index saw a one-year decline in only three out of the 13 instances. All three years, 1957, 2000 and 2008, came just before recessions.
The point is that, after inflation peaks during a time when the economy is in a good place, stocks fare well. “Even if inflation stays elevated in the coming year, if the overall inflation rate soon hits its ceiling, this has traditionally proved bullish for the stock market,” wrote Jim Paulsen, chief investment strategist at The Leuthold Group.
A rising market isn’t a sure thing. The Fed’s tightening of monetary policy could be strong enough to significantly reduce economic growth. Still, the Fed would have to raise rates fairly abruptly to disrupt economic growth and the stock market’s larger advance.
Don’t be afraid of inflation. Just watch the Fed.