In the Previous Year, Inflation Demonstrated an Unusual Behavior Not Seen Since 2009. Further Advancements in 2024 Might induce Significant Changes in Interest Rates (and the Stock Market).
The Cost of Living Index (CLI) monitors the fluctuation in cost of a collection of goods and services throughout a specific timeframe. It serves as the main indicator of inflation, and the United States Federal Reserve endeavors to maintain its growth at roughly 2% annually.
The Federal Reserve will modify the federal funds rate – the nation's foundation interest rate – when inflation veers excessively beyond or below its objective, directly affecting consumer spending, business revenue, and property values of assets such as stocks, bonds, and real estate.
In 2022, the CLI climbed to a 40-year highest, compelling the Federal Reserve to increase interest rates at an aggressive pace. This intervention appears to be effective, as inflation decreased noticeably in 2023, and continues its downward trend in 2024.
The last instance when the CLI dropped at such a pace was in 2009, and its ramifications sparked one of the longest bull markets for the S&P 500 (^GSPC 1.09%) in stock market history. Let's examine why it might happen again.
Factors triggering inflation increase
A multitude of aspects can create supply/demand discrepancies that boost inflation, including:
- Reduced interest rates and a rapid expansion of money supply (otherwise known as lenient monetary policy).
- High government spending, particularly during cash disbursements that circulate quickly in the economy.
- Supply chain issues that result in higher production costs, which translates into higher consumer prices.
Surprisingly, all of these variables were prevalent during the most intense phase of the COVID-19 pandemic in 2020 and 2021.
During this period, the Federal Reserve lowered the federal funds rate to a historical low of 0.25% and simultaneously pumped trillions of dollars into the financial system through quantitative easing (QE). U.S. government spending also surged, which encompassed stimulus checks for the majority of consumers. Lastly, global manufacturing centers periodically ceased operations to prevent the spread of the virus.
This inflationary combination caused an 8% year-on-year rise in the CLI in 2022, the most significant annual increase since 1981.
Inflation is now cooling down
The period stretching from March 2022 to August 2023 witnessed the Federal Reserve boosting the federal funds rate from its historical low of 0.25% all the way up to 5.50%. The goal was to curb inflation by counteracting some of the stimulus surging through the economy.
However, higher interest rates can increase capital expenses and dampen consumer spending, both of which negatively impact corporate profits. As a result, the S&P 500 index plummeted into a bear market in 2022, as investors favored safer assets like U.S. government Treasury bonds instead.
Luckily, higher rates did succeed in curbing the CLI to a moderately manageable 4.1% in 2023. It continues to trail the Federal Reserve's 2% target, with the most recent annualized CLI reading (April 2024) reaching 3.4%.
Consequently, the Federal Reserve does not envision raising interest rates any further. In fact, the CME Group's FedWatch tool forecasts at least one reduction by the end of 2024.
The S&P 500 saw a rebound in 2023, recording a 26.3% improvement, and is up approximately 12% this year, in tandem with the decline in inflation and the potential for forthcoming rate cuts.
Insights from 2009 and 1982
The CLI dropped 3.9 percentage points between 2022 and 2023 (from 8% to 4.1%). This was the most significant decline since 2009, and before that in 1982. Although each scenario stemmed from unique circumstances, investors often react predictably to inflation and interest rate changes.
The CLI started ascending in 2002 due to excessive consumer borrowing, fueling a housing bubble. The Federal Reserve attempted to tackle the predicament by increasing interest rates from 2004 to 2006, and the CLI ultimately peaked at 3.8% in 2008. Elevated rates, combined with the bursting of the housing bubble, resulted in a 37% decrease in the S&P 500 that year.
In 2009, the CLI slipped to a negative 0.4% (indicating deflation), marking a decrease of 4.2 percentage points from 2008. The Federal Reserve reduced rates to counteract the financial crisis in 2008, so the federal funds rate spent all of 2009 at an all-time low of 0.25%.
Despite a faltering economy and immense uncertainty, the S&P 500 still managed a 26.5% rebound in 2009. Investors cannot generate returns on their cash when interest rates are near zero, which instigates them to invest in growth assets like stocks.
The early 1980s yielded a similar outcome. The CLI reached a peak of 13.5% in 1980 and had decreased to 6.1% by 1982, thanks to aggressive rate hikes by the Federal Reserve. This decrease in inflation and subsequent rate cuts spurred a 21.5% gain in the S&P 500 in 1982, wiping out its losses from the previous year.
The S&P 500 has entered a new bull market, and it could persist for several years.
I mentioned it before, the S&P 500 witnessed a significant surge of 26.3% in 2023, and it's nearly 12% up this year at its recent levels. It even hit a new all-time high in January, officially marking the commencement of a bull market that commenced when the index experienced a low in October 2022.
This newly established bull market is approximately 19 months old, but historical data suggests it could persist for several years. For instance, 2009 kicked off a nine-year bull run, tying for the longest in history. Similarly, 1982 ignited an eight-year stretch of success.
Consequently, there's a possibility that the S&P 500 could continue to thrive in bull market conditions until 2031! Nevertheless, three factors are crucial for maintaining its momentum: The Consumer Price Index (CPI) needs to persistently decrease and stabilize around 2%, interest rates require a decline (or at least a halt in their rise), and American corporations must continue to expand their profits.
At the moment, all three situations seem plausible, indicating that investors might reap additional profits from the stock market over the near future.
Investors looking to capitalize on the current market conditions might consider diversifying their investments into stocks, bonds, and real estate, as interest rates can impact the values of these assets directly.
Given the historical trend, a prolonged decline in inflation and potential interest rate cuts could contribute to an extended bull market for the S&P 500, potentially lasting until 2031.
[Investing, money, finance]
.){kind=link}