Why Inflation Hammers Stocks (and What Ends the Pain)

Originally a thread on X/Twitter:

The current spike in #inflation has lasted longer and is more challenging to manage than expected.

The Fed is combating inflation with increases in interest rates and the equity markets aren’t happy.

Why have equities sold off and when does the recovery begin?

Inflation is the gradual increase in prices across an economy. Price increases lower the purchasing power of money.

This might sound like a universally bad thing but it isn’t. It’s widely believed that a moderate amount of inflation is necessary to sustain economic growth.

It’s only when inflation runs too high for too long that problems begin to emerge.

High inflation is a sign that consumer demand is outpacing supply (demand-pull inflation) or supply chain problems are making goods more expensive (cost-push inflation).

A 2% rate of inflation is considered healthy and manageable, but sustained rates of inflation well above this will eventually overheat the economy and push prices to the point where spending declines.

And when spending falls, a recession could be right around the corner.

Why do stocks decline when an economy starts to overheat?

Shouldn’t rising prices boost corporate profits if their higher costs can be passed on to customers?

In theory – yes. But it rarely plays out this way because the main remedy for inflation is higher interest rates.

Rising rates make credit more expensive for both companies and consumers.

Rising rates discourage companies and consumers from spending and investing.

Rising rates effectively freeze money.

And a frozen economy worries everyone.

These worries impact how investors view the equity markets in a very negative way. The current trajectory of inflation and Fed actions have caused their reaction to be downright punishing.

The why is easy to understand.

In inflationary environments, investors need to make higher returns to ensure positive real returns.

If an investment generates a 5% gain, the real return becomes 3% when inflation is 2%.

But at today’s levels of inflation, this same investment would net a negative real return.

The result: In inflationary environments the future earnings of companies have to clear a higher rate of return in order to be attractive.

Mathematically, the interest rate used in discounted cash flow analysis to determine the present value of future cash flows goes up.

Calculating the discounted cash flows for a company is a standard practice for professional investors. It requires having projections for a company’s future cash flows (earnings) and a discount rate that reflects the required rate of return (hurdle rate).

Anyone who plays around with this formula will quickly internalize the impact of discount rates on the enterprise value of a company as expressed in today’s equivalent dollars.

It matters….a LOT!

A cash flow of $100 five years from now at a discount rate of 5%, equals a present value of about $78.35.

The same $100 generated the same five years in the future is only worth $62.09 if the discount rate jumped to 10%.

And at a 15% discount rate its value drops to $49.72.

So, unless a company can confidently forecast that an inflationary environment improves its cash flows, investors will reduce what they believe the value of that company’s stock is worth.

This driver alone is responsible for many stocks falling by 20% or more. Boom!

If a company forecasts that an inflationary environment is going to hurt their cash flows due to a combination of reduced demand for their products and increased costs due to increased supply chain and labor costs, then it’s a double boom!

And because the valuation of “high growth” companies is based more on the value of their future cash flows than their current cash flows, the impact of inflation and reduced future forecasts is brutal. It’s not a triple boom….it’s a nuclear bomb!

Does this mean that inflation needs to come back down to a “normal” range before stocks will bounce back?

Aren’t steps already being taken to tame inflation and tackle supply chain issues?

Shouldn’t this be over soon and we can get back to an up-and-to-the-right market?

First, inflation can’t easily be put back in Pandora’s Box. It can last a LONG time. The Great Inflation lasted from 1965 to 1982 and it wasn’t a straight “up and down” journey. It was a roller coaster ride before inflation was squashed.

Second, cures for inflation almost always create a new set of issues.

Right now the Fed is increasing interest rates but the combination of higher borrowing costs, high inflation, and the resulting slower growth could tip our economy into a recession.

Third, it’s important to remember that the stock market is a real-time reflection of investor sentiment and aggregate expectations for the future rather than a representation of current economic conditions.

Facts matter but BELIEFS matter more.

This means that the markets will assume a “doom and gloom” future environment until there’s a general belief that inflation is under control and the economy isn’t in or headed into a recession.

Macro conditions matter but macro sentiment about future conditions matters more.

I’ll leave you with this thought: