Inflation and the Market: Back to the Future

While it is safe to say that there is always uncertainty surrounding the market, rising inflation and the prospects of a massive tax bill on the horizon are increasingly causing investors angst. With the market near all-time highs and an economy recovering from crippling lockdowns, it can be helpful to look at how previous episodes of inflation and tax increases have affected the market in the past.

Inflation and the Market

While several factors like supply chain disruptions, shortages, or changes in consumer preference can lead to an increase in price inflation, the growth of the money supply is the most influential over the long run.

In 2020, Congress and Federal Reserve intervened by flooding an unprecedented amount of newly created money into the system to support a collapsing economy. As lockdowns eased and consumers could resume normal economic activity, the bailout and stimulus money began flowing into the economy, driving up prices. Expectations by consumers for inflation are at their highest levels in a decade, putting further upward pressure on prices.

But is inflation good or bad for the stock market? A basic understanding of inflation may lead you to believe that it would be beneficial. After all, inflation is an increase in prices, and in essence, the stock market is just a price. However, in reality, the data is inconclusive. As inflation ramps up, interest rates must eventually rise to reign it in. Rising interest rates put negative pressure on stock prices as it increases the cost of capital to do business. Historically, since 1960, inflation and deflation have produced very similar returns, with deflationary periods slightly outperforming. 44% of the monthly market returns during inflationary periods were negative. Since 1947, the S&P 500 has benefited from mild inflation of between 1-4%, with an annualized gain of 9.5%. However, in environments with inflation above 4% the gains all but disappear, so the effect is not so clear after all.

Tax Reform and the Market

A likely increase in the capital gains tax rate also has investors worried. Early indications from the Biden administration hinted at a proposal that increased the top capital gains tax bracket from 20% to 39.6% (plus 3.8% Obamacare Medicare surtax). While this would only apply to the top 1-2% of earners and is likely just the starting point for negotiations, if tax laws do change, taxes are all but assured to be going higher.

However, while you may assume that higher capital gains taxes lead to negative stock market returns, history says otherwise. The last two major increases in the top capital gains rate were the Tax Reform Act of 1986 (which increased the top rate from 20% to 28%) and the American Taxpayer Relief Act of 2012 (which increased the top rate from 15% to 25.1%). In both cases, equity markets were meaningfully higher one year later (over 20% and 10% gains, respectively). While Biden’s plan calls for much higher capital gains tax rates, a proposal to make the tax retroactive to the beginning of the year could discourage investors from preemptively realizing gains to avoid paying higher taxes in the future, preventing a potential sell-off in the stock market.

Conclusion

The cloudy picture presented by historical data from the impact of inflation and tax increases on the market underscores the importance of developing a long-term investment strategy and maintaining your diversified allocation to the proper mix of stock and bonds. Check with your advisor to ensure that your investment allocations are still appropriate for your goals, but do not overreact. Abandoning your financial plan in the face of uncertainty has repeatedly proven to be more of a gamble than a sound strategy, and this time is no different.

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