We have been hearing about inflation concerns for months. On Wednesday, Federal Reserve Chairman Jerome Powell said temporary inflation could last into next year. Also on Wednesday, the normally very bullish Prof of Finance, Jeremy Siegel from Wharton said a fresh surge of inflation is making him nervous. He went on to say, that inflation could cause the Federal Reserve to have to raise interest rates faster than anticipated, and that could lead to a market correction. Let’s break these comments down and discuss three scenarios I see for the market.

First, context. In my last article, “The US Stock Market in Three Charts“, I gave an update on earnings and valuation for US stocks. In a nutshell, earnings have been very strong, and although the PE level for the S&P 500 at 22 X is elevated from the 18-19 X that we were averaging before the pandemic, are in line with historical equity premiums compared to interest rates. Consider this a long-term or ‘steady state’ baseline. On the other hand, if we did get significant change in interest rates we would see short-term volatility and/or market corrections. Here then, are three scenarios for short-term market outlook based on inflation and interest rates.

Scenario 1: Inflation shock leads Fed to raise rates faster than anticipated (Siegel’s Fear). Odds: 30%

First, how would this scenario play out. As Siegel suggested, if the Fed is forced to raise rates to stop inflation the market would likely react with a correction. Why? We have already noted earnings are growing, so why would the market correct? It has to do with the equity premium discussed in the last article. To invest in riskier stocks, we need to be compensated for that risk. If bond rates go up then we expect that we get paid more from stocks. The only way to accomplish this is to reduce the price (so that the return goes up). As we have noted, a small bit of inflation is good for stocks. Earnings have been great because in part companies are passing on the price increases to customers and earnings go up.

Now, even in this scenario, we need to ask what is the long-term effect? If rates stay in the 1.5 – 2.0% range, the premium discussed in last article would be ‘fair’. Unless rates rise significantly from the current levels, any market correction would be temporary. We would expect to see a bounce back in prices over a short period of time (one to six months).

Scenario 2: Inflation slowly recedes in mid- to late-2022, economy resumes steady growth (but slower than before). Odds: 50%

The Federal Reserve is in absolutely no hurry to raise rates. First, they changed policy and said they are willing to let inflation run ‘hot’. They are now using an inflation averaging method that would allow rates to run above 2% for a period.

Secondly, the Fed has a dual mandate to ensure full employment. Just as in the ’08 – ’09 crisis, we are experiencing low participation rates. Workers have left the work force. Jerome Powell continues to say that the economy is not out of the woods yet.

Finally, the Federal Reserve for all of its faults does seem to be able to adjust policy based on prior events. They raised rates in late 2018 and the market threw a fit. By early 2019, they had to reverse course and reduce rates. My sense is, Powell will not make the same mistake.

Scenario 3: Persistent inflation leading to permanent increase in rates to 3-4%. Odds 20%

Previously, I penned a blog, “I’m Not Betting on Sustained Inflation”. I summarized key ideas put forth by three top economics on the topic of inflation. Here I am talking about long-term inflation. Yes, we have had some short-term supply-demand shocks that have caused inflation. Competition, innovation, aging populations and high government debt are all forces which counter inflation.

Net, Japan has been trying for decades to manufacture inflation. The US, prior to the pandemic could not get to the 2% inflation target even after hugely accommodative measures. Now, in the pandemic the US unleashed trillions of dollars of fiscal stimulus – raising personal incomes by 30%! There is no wonder that inflation shows up with big parts of the economy shut down and the government writing checks to people (on borrowed money). The US is now over 100% debt to GDP ratio and the government is simply running out of money, future stimulus won’t be easy to come by. This will be very deflationary.

Conclusion

Timing the stock market is very difficult. However, ignoring reality would be an equally bad idea. Scenario analysis like this can be used to form better strategy. The US economy is the strongest in the world. Scenario one and two above are roughly my 80% base case. If stocks were highly over-valued relative to the equity premium, we would give this scenario more action and perhaps cut equity weights. However, with a backdrop of long-term moderate interest rates and normal inflation, continuing with prudent diversification is the preferred path.