Inflation’s Impact on the Market
Key Points – Inflation’s Impact on the Market:
- Equity Markets in Good Shape
- High-Yield Bonds Lead to Fixed Income Space
- Understanding the Long-Term Outlook of Inflation
- Money Velocity Drives Inflation
- Today’s Housing Prices Compared to Those Before The Great Recession
- 6 minute read | 11 minutes to watch
Crazy things are happening in the market: the stock market, bond market, housing market, inflation’s impact on the market, interest rates. I’m Dean Barber, founder and CEO of Modern Wealth Management. Stick around for this month’s economic update.
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Equities Markets Rise
Let’s get started with what happened in the equities market. If we think about the equities market, we really saw another month, August, where most sectors of the equity markets improved.
Figure 1 | Source: chaikinanalytics.com
Outlined above in Figure 1, you’ve got the NASDAQ Composite, the winner of August, up 4.22%. Dow Jones Industrial Average brought up the tail end, up just 1.27%. Everything was between 1.27% and 4.22%, so there were good gains across the board to add to the good gains for the year.
Figure 2 | Source: chaikinanalytics.com
If we look at year-to-date numbers above in Figure 2, the RSP equal-weight S&P 500 is up 22.55%. That’s followed by small cap value, up 22.34%. Down at the bottom is Russell 2000. All these continue to look extremely good. We have seen more attention in the last month or so of money coming back into technology. We could see tech finish the year strong. Overall, equity markets look good.
The Correlation Between High-Yield Bonds and Fixed Income Space
Figure 3 | Source: ycharts.com
Let’s turn our attention to the bond market above in Figure 3. One story that’s prevalent in the bond market is that high-yield bonds are leading the fixed income space this year. If we look at the purple and the blue, those are the Barclays Bond AGG and Bloomberg U.S. Corporate. Those are in negative territory this year where the high yield is up 3.5%.
I don’t have it on Figure 3, but we are also seeing good returns from mortgage-backed securities and senior-secured debt. Those are up at about 3.5% to 5%. We have bond market sectors in positive territory despite seeing the 10-year yield rise from the beginning of the year.
Revisiting Valuations on the Market
Figure 4 | Source: ycharts.com
Let’s talk about valuations on the market. We did this earlier this year, but I think it bears repeating. There are a couple of things going on above in Figure 4. First, the purple line is the inflation rate. The S&P 500 is the orange. This is going all the way back into 2000. We did that because I wanted you to see the inflation and what’s happening with the S&P 500 overlaying each other.
The other one is the CAPE ratio, which is the cyclically adjusted price-to-earnings ratio. You can see where it was back in 2000 and where we are today. We are very near the level that it reached in 2000, just before the Dot-com Bubble.
The CAPE ratio is sitting at 38, which is extremely high from a long-term perspective. The only time it was higher than that was in the early part of 2000s, late 1999, right at the Dot-Com Bubble’s peak.
Onto Inflation’s Impact on the Market
Figure 5 | Source: ycharts.com
Now, let’s go into inflation’s impact on the market. This is going way back to 1900 up to now, so you can see inflation. If anybody remembers the inflation of the late ’70s and early ’80s, it’s in the center of Figure 5 that is outlined above. Inflation has been all over the board. We saw it as high as 24% in the early 1920s.
Inflation is now running at an average of 5.37%. That’s over on the right side of Figure 5. You can see that little spike in inflation. When was the last time we saw inflation spike up like that? It was in 2004, 2005. What we’re seeing today from an inflationary perspective is nowhere near what we saw in the late ’70s. Inflation is obviously a big deal. We’re keeping a close eye on that. We want to understand the longer-term outlook of how inflation impacts the market.
Money Velocity Makes It’s Mark on Inflation
Figure 6 | Source: fred.stlouisfed.org
We’ve talked about this on many of our updates, but velocity of money is one thing that drives inflation. If we look at the velocity of money, I’ve overlaid the 10-year treasury constant maturity rate in blue, alongside money velocity in red. If we go back to 2000, money velocity has steadily declined. There have only been a few periods where money velocity has slightly picked up.
Money velocity is something that must be present for inflation to remain. Money velocity is simply defined as the number of times per year that a dollar changes hands. You see this huge drop-off on Figure 6, where we had the start of COVID. Money velocity hasn’t picked up since. It went down and came back up a little bit, but it’s flatlined now. Until the money velocity picks up, it’s difficult to see any longer-term sustained inflationary pressures.
Sky-High Housing Prices
Let’s turn our attention to housing for just a minute. This is a phenomenon that’s been happening over the last year. Housing prices have come up a ton. I want to do two things here. First, I’ll take you back to what home values were before the Great Recession, and where we are today. I also want to look at U.S. existing home sales prior to the Great Recession, and where we are today.
Figure 7 | Source: ycharts.com
Above, on the top half of Figure 7, the value of homes is up nearly 40% than the peak, which was June 2006. The average price of a home then was $277,700. It’s now $383,600. Depending upon which market you’re in, you’re going to see different variations of how much home prices have increased.
If you look at Figure 6, you could draw a straight line in 2018, 2019. That increase in housing has come in the last couple of years. Inflationary pressures on housing are a phenomenon that is being fueled by the ultra-low interest rates. People can afford to pay much more for a home because their home payment is less due to low interest rates.
We did a piece on this where we talked about the amount of debt that’s out there, which was on last month’s economic update. Although debt has increased substantially over the last 20 years, the amount of debt service versus the amount of income people are making is down about 14% in that time. That’s a big deal.
Upward Pressure on Housing Values
Look at the number of U.S. existing home sales on Figure 7. We’re sitting at $5.99 million, still below the housing market’s peak in 2006. We have seen that tail off and soften a little bit. If home prices continue to elevate at this rate, expect U.S. existing home sales to continue to cool off and drop. That should start leveling the values of houses.
I think the value of housing is going to continue increasing because we have a shortage. I don’t want anybody to believe that the housing market today resembles the bubble we saw in 2006. At that point, we had a massive oversupply of houses. Today, we have a massive undersupply of houses. A lot of that is driven by the millennial generation that’s beginning their family formation years and moving out of apartments into single-family homes.
We think that phenomenon of people looking for houses will continue. If we continue seeing interest rates as low as what we see them today, I anticipate we’ll continue seeing upward pressure on housing values.
What Can We Expect with a Strong Economy
The economy looks strong. We expect continued economic growth through this year, 2022, and 2023. From a longer-term economic outlook, there’s a lot of positivity that does not necessarily translate into equity markets that are moving higher, especially with today’s levels.
What it tells us is that with a strong economy, unless something comes out of left field, we’re probably going to see the markets support the level that they’re at. Some earnings could grow into those prices if we see money velocity pickup and consumer spending stay strong. However, I would not expect to see the same types of returns for the balance of this year as we’ve seen in the first eight months.
Thank You, Loyal Listeners!
As always, I encourage you to keep the lines of communication open with your advisors at Modern Wealth Management. Talk to us and let us know if anything’s changed. If you’ve got questions, we’re happy to visit with you. Thanks so much for joining me for this month’s economic update.
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Dean Barber Founder & CEO
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