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November 19, 2021 | Macro Insights

Rise in Inflation May Not Spell Trouble For Financial Assets

Investors tend to worry that rising inflation will hurt their investments. Our analysis shows that this is not necessarily the case. We found that the type of inflationary environment matters—particularly when it comes to equities. In this study, we look at the real returns of US equities and US bonds since December 1947, paying close attention to how each performed in different types of inflationary environments—those in which a more modest pace of price increases starts to accelerate and those when price increases follow a period of deflation.

Inflation: Elevated Now, Moderating Later

Rising inflation has been a growing concern over the last few months for the major economies. In the US, the core Personal Consumption Expenditures price index, the Fed’s preferred inflation measure, rose 3.6% in the year to September, a level last seen in the 1990s. Even in the Eurozone, where inflation has remained well below the central bank’s target since 2008, has observed a similar uptrend. The persistence of elevated inflation — which is being fueled by pent-up demand, ongoing supply chain disruptions and rising energy prices — is now cause for concern for many investors.

Exhibit 1

Source: As of November 19, 2021. Bloomberg, and Goldman Sachs Asset Management. The table shows the annual consumer price inflation rates. The asterisk refers to Bloomberg consensus. Past performance does not guarantee future results, which may vary.

 

Key Lessons From History

In order to assess the implications of rising prices for financial markets, it is useful to look at the past to better understand what may lie ahead, while recognizing nuances that are present today. We have identified 11 periods of rising inflation in the US since World War II (Exhibit 2), and two types of inflation dynamics based on the initial levels: inflationary periods that follow deflation (Exhibit 3, grey bars) and inflationary periods starting from positive levels (Exhibit 3, blue bars).

Exhibit 2

Source: As of October 26, 2021. Federal Reserve Bank of St. Louis, Shiller, and Goldman Sachs Asset Management. US Bond Returns are derived from Shiller's database and implied by the monthly market yield on U.S. treasury securities at 10-year constant maturity. GDP, S&P 500 and US Bond changes are expressed in real terms. Past performance does not guarantee future results, which may vary.

 

Exhibit 3: Inflationary Periods

Source: As of November 11, 2021. Shiller, and Goldman Sachs Asset Management. The time period is from December 1947 to October 2021.

 

Looking at real returns of the S&P 500 and US bonds during these periods, we find that inflationary environments starting from non-negative levels of inflation were on average negative for both equity and bond prices, despite real economic expansion. In equity markets, this may be because higher input costs put downward pressure on corporate profit margins, in turn reducing expectations for earnings growth. Falling bond prices—and rising yields—are largely the result of investors anticipating tighter monetary policy ahead. However, inflationary periods that followed deflation had more nuanced implications for financial assets. We see that this specific inflation regime was associated with positive real equity returns and negative real bond returns. This may imply that initial inflation levels matter for financial markets as they may affect asset prices in different ways.

Exhibit 4: Performance During Inflationary Periods

Source: As of October 26, 2021. Federal Reserve Bank of St. Louis, Shiller, and Goldman Sachs Asset Management. The time period is from December 1947 to March 2021. US Bond Returns are derived from Shiller's database and implied by the monthly market yield on U.S. treasury securities at 10-year constant maturity. Arithmetic average of the performance of the periods identified in Exhibit 2. Past performance does not guarantee future results, which may vary.

 

Another important element is the duration of inflationary periods. A transitory rise in prices may affect assets differently than a more persistent one. Our analysis suggests that transient inflationary episodes remain positive for equities in real terms. On average, the S&P 500 had an annualized real return of about 6% during the inflationary periods identified lasting less than two years but negative real returns in more persistent inflationary environments. Although US bond performance was negative in both scenarios, prices fell less when inflation was transitory.

So, What's Next?

While we do expect inflation to edge higher as 2021 winds down, we anticipate that these price increases will moderate next year as base effects fade and as a demand shift from goods to services allows bottleneck price pressures to ease (see Fixed Income Outlook 4Q2021, Business as (Un)usual, October 11, 2021). A multitude of factors can affect asset prices and inflation is only one of them, albeit an important one given its implications for monetary policy. Nonetheless, the analysis of the following disinflationary periods (Exhibit 6) suggests that equities performed well when inflation fell from high levels, with the exception of the dot-com bubble (Exhibit 5, period 7) and the Global Financial Crisis (Exhibit 5, period 9). Bonds have the potential to do well in most disinflationary episodes too. This seemed to be true regardless of the magnitude and the speed at which inflation deflates.

Exhibit 5

Source: As of October 26, 2021. Federal Reserve Bank of St. Louis, Shiller, and Goldman Sachs Asset Management. US Bond Returns are derived from Shiller's database and implied by the monthly market yield on U.S. treasury securities at 10-year constant maturity. GDP, S&P 500 and US Bond changes are expressed in real terms. Past performance does not guarantee future results, which may vary.

 

Exhibit 6: Following Disinflationary Periods

Source: As of November 11, 2021. Shiller, and Goldman Sachs Asset Management. The time period is from December 1947 to October 2021.

 

We Still Favor Equities into 2022

Our analysis shows that when inflation rises from negative or near-zero levels, it may not negatively affect equity prices in real terms as opposed to other types of inflationary periods. However, the opposite seems to be true for bonds regardless of the initial level of inflation.

The duration of inflation episodes is another important element to consider – a long-lasting rise in prices may have adverse effects on equities and bonds, while a temporary spike in prices may weigh less heavily on the performance of the two assets.

These are some of the reasons why we think equities should remain the preferred asset class for investors in the current environment. We see three additional factors supporting equities through 2022: 1) global growth that is moderating but still above trend, 2) ongoing vaccinations that will support a recovery on the services side of the economy and, 3) easy financial conditions given gradual normalization of monetary policy.

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