Wall Street has been trying to shake off a couple of strong inflation reports released in the last two days confirming that inflation is turning from a temporary to a permanent problem.
The Labor Department reported Wednesday that the Consumer Price Index, a measure of retail inflation, rose at an annual rate of 7% in December, up from 6.8% in November. That’s the fastest pace since the summer of 1982. The same agency reported that the Producer Price Index, a measure of inflation at the wholesale level, rose at an annual rate of 9.7% in December, in line with the November increase.
Meanwhile, a third report released Thursday by the Department of Labor showed that 230,000 Americans filed for unemployment benefits last week, up 23,000 from the previous week. Though weekly unemployment claims are highly volatile due to all sorts of factors, they could be a sign that the economy isn’t growing fast enough to help people find jobs.
If that turns out to be the case, the economy could be heading to stagflation, a situation of high inflation, and slow or even negative economic growth. That’s what happened in the 1970s and the 1980s, when, under several supply-side shocks, the economy experienced both high inflation and negative economic growth.
Stagflation is the last thing Wall Street traders and investors want to hear, as it is terrible for both the debt and the equity markets. For the debt market, inflation pushes bond prices lower and yields higher, meaning that investors on the long side of the long end of the yield curve stand to lose a great deal of money from rising interest rates. For instance, the 30-year U.S. Treasury bond yields in the 1980s were in the mid-teens, multiple times higher than the current rates of 2%.
For equity markets, stagflation is a double-punch. Economic stagnation shaves off earnings growth, while higher inflation and higher interest rates make future earnings less valuable when they are discounted to the present. When taken together, both factors drive equity valuations lower, and eventually, equity prices.
Still, inflation and labor market reports are distorted by the resurgence of the COVID-19 infections, which affect the functioning of commodity and resource markets. That means that numbers on both inflation and economic growth may look much better once the pandemic is over. Thus, Wall Street’s tendency to shake-off adverse macroeconomic reports.
For instance, on Wednesday, all major averages opened higher, only to turn briefly negative by late morning and end up the trading session positive. Then, on Thursday, all major indexes opened higher again but quickly turned mixed by late morning, with the tech-heavy Nasdaq suffering the more significant losses.
While it’s still unclear when the COVID-19 pandemic will end and how the economy will respond to it, one thing is clear: volatility on Wall Street will continue, and only companies with solid fundamentals will survive and thrive.