How Inflation Threatens Your Stock Gains In 2018

"Just a little bit more inflation from where we are today is probably enough to generate an inflation scare in 2018," according to Don Rissmiller, chief economist at Strategas Investment Partners, in remarks to Barron's. Moreover, "inflation is the ultimate enemy of financial assets," as Lloyd Khaner, president of Khaner Capital Management, told Barron's.

The consensus of economists is that inflation in the U.S. probably will rise to an annual rate of between 2% and 2.5% in 2018, but that is probably more than enough to create an inflation scare, Barron's indicates.

The worst bout of inflation in modern U.S. history occurred during the 1970s. In order to cement his chances for re-election in 1972, President Richard Nixon looked to stimulate the economy. To this end, he installed presidential counselor Arthur Burns as chairman of the Federal Reserve, then pressured Burns to adopt an easy money policy. The rapid expansion of the money supply under Burns sent inflation soaring to 8.8% in 1973 and eventually to 14% by 1980.

From January 1973 to October 1974, the S&P 500 Index (SPX) fell by 48%, and would not regain its starting value until 1980, per Yardeni Research Inc. It would take tight money policies under Paul Volcker, sending short-term interest rates near 20%, and setting off the worst recession between the Great Depression of the 1930s and the Great Recession of 2007-09, before inflation returned to the low single digits. (For more, see also: The Great Inflation of the 1970s.)

Barron's outlines five major ways in which rising inflation would affect investors today, mainly negatively. These are:

1. The P/E multiple on stocks is negatively correlated with inflation, based on data from 1950 onwards. At an inflation rate of 0% to 2%, as measured by the CPI, the average stock multiple is 18.1, but sinks to 17.2 at inflation of 2% to 4%, and plummets to 8.8 when inflation exceeds 8%.
2. Stocks that are sensitive to interest rates, most notably utilities and telecom companies, would decline in price, as inflation pushes up interest rates. However, inflationary price increases could help earnings, and stock prices, among financial, energy, and materials companies. Profit margins tend to expand at banks when interest rates rise. Energy and materials producers would ride a wave of higher commodity prices (see below).
3. Bond prices would sink. Worse yet, given the low coupon rates on recently-issued investment grade bonds, the yields on this debt would drop to negligible, if not negative, levels on an inflation-adjusted, real basis. One notable exception should be inflation-protected bonds such as TIPS, whose principal value rises with the CPI.

If President Trump succeeds in imposing trade restrictions, in line with his campaign promises, that would provide another impetus for inflationary price increases. In fact, Barron's observes, a recent jump in lumber prices is largely the result of new import tariffs.

Inflation is a particular worry for retirees, The Motley Fool observes. The declining number of retirees who receive a traditional pension with a fixed monthly dollar payout will, of course, see its purchasing power decline. As noted above, retirees with fixed income investments will suffer declines in the principal values thereof, as well as in the purchasing power of the interest payments thereon, with the exception of investments in inflation-protected bonds.

On the other hand, moderate inflation tends to support higher stock prices on average, the Motley Fool adds, meaning that retirees should maintain a significant allocation to equities as an inflation hedge. The Fool indicates that, since 1913, inflation in the U.S. has averaged about 3% per annum.