SP500 & Inflation Update: Aug 2023

The July headline CPI release followed predictions of a slight increase, yet the actual magnitude was less significant than anticipated. This outcome sparked optimism within the market, leading to a surge in activity and speculation of a potential pause in rate hikes. However, this optimistic rally was short-lived as market participants quickly adjusted their expectations. The weaker-than-expected inflation reading meant a potential decline in economic demand. This perspective gains support from jobless claims data released a few days back, that showed claims rising to a 1.5-year high. Consequently, there’s now a debate over whether further inflation reduction is beneficial or detrimental to the markets.

To grasp this situation, it’s crucial to comprehend the interplay between the SP500 and inflation. Inflation profoundly affects the valuation of S&P500 and every other asset in the economy. As inflation rises, valuations tend to decrease, and vice versa. However, if inflation drops too low, the risk of deflation can trigger a downward spiral in valuations. But generally, when inflation is predicted to decrease, valuations are expected to rise. However, the current scenario defies this logic, as valuations stayed elevated when inflation was rising. This contradiction is due to the anchoring of future inflation expectations. This unique situation, deviating from the long-term inflation-valuation relationship, has occurred only once since the 1950s, specifically during 1965-1972.

Drawing parallels between that historical period and the present, we can extrapolate potential outcomes. In the 1965-72 era, after a brief turmoil, the valuations remained relatively flat, aligned with anchored inflation expectations. As inflation subsided, the relationship between valuations and inflation realigned with its long-term trend. In the current scenario, a similar pattern might unfold. If core inflation steadily decreases and the Federal Reserve maintains its course, valuations are unlikely to experience a significant collapse. The primary risk to the S&P500 index would then stem from diminishing earnings. A decrease in earnings would correspondingly lead to a lower S&P500 index, particularly if the Shiller PE valuation remains constant.

Hence, if an earnings downturn for the S&P500 is anticipated, (Which at Airtham we do expect), a lower S&P500 index should be expected.