After Their Epic Rally This Past Year, Stocks Face Inflation Risks in 2021

By Nicholas Jasinski

Updated January 4, 2021 / Original December 31, 2020

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The Dow Jones Industrial Average and the S&P 500 both ended the year at record highs. Above, a trader on the floor of the NYSE on New Year’s Eve.

Courtesy of NYSE

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It was a quiet, low-volume trading week sandwiched between Christmas and New Year’s, one that all but demanded that a financial journalist mull over the big questions for the year ahead. And none might be bigger than what happens to inflation.

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The Dow Jones Industrial Average finished the week up 406.61 points, or 1.35%, at 30,606.48, while the S&P 500 rose 1.43%, to 3756.07—both record highs. The Nasdaq Composite added 0.65%, to 12,888.28.

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It was a modest finish to a tumultuous year in which stocks tumbled into a bear market in just a matter of weeks in February and March, then embarked on a vertiginous rally. The S&P 500 closed up 16.26% for 2020, and has gained just shy of 50% over the past two years, its largest two-year gain since 1999. The Dow added 2068.04 points, or 7.25%, in 2020, while the Nasdaq roared 43.64% higher last year. The small-cap Russell 2000 gained 18.36%.

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Outside of asset markets, inflation didn’t make its presence felt much in 2020. Excluding volatile food and energy components, the core consumer price index, or CPI, rose by 1.6% year over year in November, the latest month available. The Federal Reserve’s preferred inflation measure, the core personal consumption expenditures price index, or PCE, increased by 1.4%. Core CPI hasn’t been above 2% since March, while core PCE hasn’t touched it since 2018.

That’s expected to change in the coming year, at least a little bit. Economists’ consensus estimate is for a 1.8% increase in core CPI in 2021, according to FactSet, and the Federal Reserve’s latest summary of economic projections also has core PCE inflation rising to 1.8% in 2021, on its way to 2% in the longer run.

Some pickup in inflation isn’t a fringe viewpoint: An RBC Capital Markets survey of investors in December found that 59% of respondents believed that inflation will accelerate in the coming six to 12 months. An important question, however, is whether that acceleration lifts inflation into a faster-growth Goldilocks zone, or meaningfully above that.

An inflation rate near the Fed’s 2% target would be a positive development, reflecting a healing economy and creating incentives for investment and spending. It also keeps the deflationary “death spiral” scenario at bay.

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But there are several strong, albeit theoretical, arguments in favor of an even greater pickup in inflation. That’s far from priced into equity or fixed-income valuations, and a faster rate of price increases would be a major shock to markets if it does appear later in 2021.

“Unlike most Fed officials, I do not have a high degree of conviction on where inflation is headed in 2021, but I view a pickup to above prepandemic levels as at least as likely as a continuation of softer increases,” writes Stephen Stanley, Amherst Pierpont’s chief economist.

Foremost in favor of higher inflation is the unprecedented scale of money-printing by the Fed in 2020. Since March, the supply of U.S. dollars has increased by almost 25%. In other words, about 1 in every 5 dollars that exist today have been created in the past nine months. Monetarist theory, which focuses on the macroeconomic effects of changes in the money supply, is screaming for an increase in prices under such a massive expansion. Combine that with a surge in postpandemic demand that could outstrip supply, government deficits that aren’t going away, and the Fed’s new policy framework that will tolerate an increase in inflation, and it’s possible that upward pressure on prices arrives sooner rather than later.

If greater inflation lifts market rates—or spurs the Fed to step in with higher interest rates sooner than expected—the investment implications are significant. “What people don’t fully realize in my view is that we’re entering a very different investment world than what we’ve gotten used to in the past decade,” says Mike Wilson, Morgan Stanley’s chief U.S. equity strategist. The bank’s economists expect the 10-year yield to rise to 1.45% by year end, from 0.913% at the end of 2020, and for the 30-year to hit 2.40%, from 1.642%.

The counterargument to the inflation hawks is that the past decade of low inflation has shown us that it’s not purely a monetary phenomenon—and that maybe monetarist theory isn’t worth all that much in today’s world. Disinflationary structural forces remain, including an aging population that prioritizes saving over spending and technological improvements that reduce costs and boost productivity. Plus, pent-up demand spending may prove temporary and limited to specific services like airfare, high unemployment could keep wages down, and commercial rents could remain under pressure, eliminating another source of rising costs.

In the stock market, bond-proxy sectors like utilities and real estate stand to lose from a rise in inflation and rates. So do richly valued growth and technology stocks, which would see their multiples drop. Future earnings are worth less today under a higher discount rate.

Conversely, bank stocks, most of all, stand to gain from a potential sustained pickup in inflation. Banks’ net interest margins and profits rise the more that long-term rates exceed short-term ones—their bread-and-butter business is borrowing short to lend long. Add an improving economy, the Fed’s green light for greater capital returns to shareholders, and cheaper relative valuations, and banks could be the place to be in 2021. The Invesco KBW Bank exchange-traded fund (ticker: KBWB) is an efficient way to play the group.

There’s no guarantee that the postpandemic world will in fact feature sustained inflation above 2%, or that central bankers will respond sooner than expected with higher interest rates. But it’s a large enough tail risk—with significant enough implications—that it can’t be ignored. And if 2020 has taught us anything that can be applied to 2021, it’s better not to dismiss the tail risks.