Stocks, Bonds, and Higher Inflation

By Charlie Bilello

05 May 2021

US inflation expectations continue to rise, now at their highest levels since 2008.

If higher inflation is coming (see here for some signs), many investors are wondering how that will impact their portfolio. Let’s take a look at how stocks and bonds have performed historically under various levels of inflation…

If we segment calendar year changes in the Consumer Price Index (CPI) into quintiles, we observe the following:

  • The lowest real equity returns have occurred in deflationary (quintile 1) and high inflation (quintile 5) environments while the highest real equity returns have occurred in periods of low (quintiles 2/3) to moderate (quintile 4) inflation.
  • The lowest real bond returns have occurred in high inflation (quintile 5) environments while the highest real bond returns have occurred in deflationary (quintile 1) and moderate inflation (quintile 4) environments.
  • From an economic perspective, we’ve seen higher odds of a recession and lower real GDP growth at both ends of the inflation spectrum, with deflationary environments (think Great Depression, 2008 recession) being the worst historically but high inflation environments (think 1970s and early 1980s) not far behind.

Which quintile are we in today?

With CPI up 2.6% over the past year, we’re right in the middle of the 3rd quintile, a so-called “Goldilocks” environment with inflation running neither too hot nor too cold. However, there is a strong potential for a shift to the 4th quintile in the coming months as sky-high consumer demand via stimulus payments exceeds existing supply.

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What does that mean for stocks and bonds?

If high inflation is coming, history suggests a more difficult time for both stocks and bonds (lowest real returns on average were in the highest inflation quintile). But with inflation currently running at 2.6%, we’re not approaching that scenario just yet. It’s also important to note that inflation is just one of many factors that can influence the returns of stocks and bonds.

In the short run, bond returns are most heavily dictated by the direction of interest rates and stock returns by the direction of investor sentiment (are investors willing to pay more or less for a given level of earnings?).

With 10-Year Treasury yields still quite low (1.59%), if higher inflation rates are accompanied by rising interest rates (they typically are as there’s a high correlation between the two variables), this would suggest a more difficult road for bonds.

On the stock side, the answer is less clear as you must forecast not only how much inflation will rise but also how investors will interpret such an increase. Thus far, they’ve viewed higher inflation as a bullish sign that economic growth and corporate earnings are set to boom. We’re already seeing that play out with S&P 500 EPS hitting new highs in Q1, and continued gains expected throughout the remainder of the year.

But at a certain point, investors may begin to view inflation as running “too hot,” and begin to fear the Fed shifting away from its easy money policies (0% rates, QE). This, in turn, could lead to fears of an economic slowdown and a resulting contraction in multiples.

If inflation doesn’t rise to the highest quintile, does that mean stocks can’t go down?

Not at all. While the “goldilocks” quintiles (2-4) have historically shown higher returns and more positive years than inflationary/deflationary regimes, there are a number of exceptions.

Most recently, stocks declined in 2000 (-9.2%), 2001 (-11.9%), and 2002 (22.1%) with CPI registering 3.4%, 1.6%, and 2.5% during those years (see appendix below for details).

This should serve as a reminder that the level of inflation is only one of many factors influencing equity markets. There is no precise formula for predicting what stocks will do and when they’ll do it. Inflation is likely to move higher in the near term to levels we haven’t seen in quite some time, but what that means for stocks ultimately comes down to how investors interpret that move.


Stock Returns (S&P 500) During Various Inflation Regimes

Bond Returns (10-Year Treasury) During Various Inflation Regimes

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