3 reasons why inflation may not spoil the stock market rally

There is an opportunity for longer-term investors to pick up structural winners at discounted prices.

With growth coming back in the economy, the fear of rising inflation also seems real. The US stock market last month in May was witness to the inflation worries as investors remained confused to a large extent. US Fed may believe inflation to be transitory but better evidence has to emerge to maintain that inflation won’t remain a permanent feature in the long run.

The Consumer Price Index, the Producer Price Index, the Personal Consumption Expenditures Index, and the wage growth component of the monthly employment report that captures job growth and the unemployment rate may remain on the radar of global investors in the near future. What remains a major concern is whether inflation will dent the equity prices and put pressure on the stock market rally going forward.

Chief Investment Office, UBS, in their daily updates are of the view that the equity rally should survive inflation concerns.

“But while we have been warning investors that inflation fears could generate volatility, we do not expect price pressures to bring the equity rally to an end,” says CIO, UBS in the daily updates.

Here is why, according to them, inflation may not put price pressures to bring the equity rally to an end:

The forces pushing up inflation are not likely to be sustained: The rise in inflation, in our view, reflects two short-term factors. The first is that prices were weak at this point last year when pandemic lockdowns were at their most restrictive. This year-on-year comparison effect will fade.

Second, inflation has been pushed higher by the rise in the price of commodities, such as oil, from artificially low post-pandemic levels. The price of Brent crude has risen, for example, by around 130% over the past 12 months from just under USD30 a barrel to USD 69 barrel. While raw material prices may climb further, we believe the bulk of the rise in commodity prices is now over.

Price increases have not been broad-based: Central banks monitor the “trimmed mean” inflation, a measure that excludes prices that are rising and falling most. Instead, the gauge focuses typically on 70% to 90% of prices, and these have been remarkably stable. Recently, the US measure has barely moved from 2% year-on-year. Sweden and Canada are the same. Japan, the UK and Australia are at or close to lows. For most countries, most prices are no cause for concern.

Central banks response: Federal Reserve Chair Jerome Powell has repeatedly indicated that the rise in inflation was “largely reflecting transitory factors.” Meanwhile, the Federal Reserve has suggested it is willing to let the economy run hot after years of undershooting the 2% target.
Fed officials underlined this dovish message, with Fed Governor Lael Brainard saying policymakers should be patient as the post-pandemic distortions sort themselves out. Philadelphia Fed President Patrick Harker said it would be “premature” to talk about tapering.

What should investors do

So, given the view, Chief Investment Office, believes the spike in inflation will prove transitory, and the equity rally has further to run and they believe investors can use volatility to invest and protect. Concerns about inflation have led to particular weakness in recent days for growth stocks, presenting a potential opportunity for longer-term investors to pick up structural winners at discounted prices. Finally, inflation has not proven a hindrance to the recovery in corporate earnings, with S&P 500 companies so far beating earnings forecasts by around 24%.