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Inflation. It’s the latest worry for Wall Street.

Investors are becoming overwhelmingly convinced a pop in prices is coming, a situation that could derail markets. The reason: The U.S. government is eyeing a whopping $1.9 trillion stimulus package (or “stimmy,” as the kids call it).

It’s another round of historic help, which has amounted to 27% of gross domestic product since the pandemic began. Trillions in stimulus could be a game-changer for the economy, but there could be one big side effect: a burst of inflation.

Chart title reads Inflation Expectations Soar. Chart shows inflation expectations in the bond market (measured by the 5-year breakeven rate) with the COVID-19 pandemic timeframe highlighted.

Don’t get us wrong, inflation running ahead of 2% for a while wouldn’t hit your wallet too hard, and it would be a sign of a healing economy. But a surge in inflation is becoming more of a concern, and it could be a big deal for your portfolio.

Too Much Inflation

Inflation generally takes place when the economy is doing well and consumer spending is healthy. It all boils down to supply and demand: If people buy more of a product, the price of that product will rise.

Take food, for example. People stocked up on groceries at the beginning of the pandemic. Remember the run on toilet paper? As a result, grocery prices in April surged more than they have in 45 years.

There can be too much inflation, though. If prices climb faster than incomes, consumers eventually won’t be able to afford higher prices.

Today, inflation is subdued. Year-over-year growth in the core Consumer Price Index (CPI), which excludes volatile food and gas prices, hasn’t jumped above 2% since March. However, consumers’ savings are high, and there’s lots of pent-up demand. At the same time, global supply chains are still broken.

Price pressures are already popping up in areas where the mismatch between supply and demand exists. Inflation expectations via the bond market are the highest they’ve been in years. December’s ISM manufacturing report also showed selling prices rose at the fastest pace in a decade.

Stocks and Inflation

Investors should watch the pace of inflation closely. Stock returns tend to decrease as inflation increases because the value of a company’s future cash flows falls as inflation eats into what a dollar today is worth tomorrow. Rapid inflation growth can also signal a change in the business cycle, which can make any investor nervous.

Since 1990, the S&P 500 has notched higher one-month and 12-month returns in low inflation environments (when core CPI growth is lower than 2% year over year).

Chart title reads Higher Inflation, Lower Returns. Chart shows average S&P 500 returns since 1990 at different inflation levels. Since 1990, the S&P 500 has notched higher returns in the current month (1.4%), six-month (7.2%), and 12-month (11.7%) period following an environment where inflation is 2% or lower.

It’s not just the rate of inflation that can impact stocks. Runaway inflation can be a tricky dynamic, too. Stocks have posted lower returns in quarters when core CPI has increased rapidly. In fact, inflation scares have led to economic downturns and bear markets. The S&P 500 fell 27% in the early 1980s when inflation jumped above 10%, and the U.S. economy entered a six-month recession.

While we’re nowhere near the raging inflation of the 80s, stocks could still be vulnerable to a jump in prices. If inflation rises too quickly, it could force the Federal Reserve to unwind its historic market support by either curbing its bond-buying program or raising rates. We don’t think this is a big risk, especially because Fed policymakers have made it clear that they want to see persistently high inflation before they act. But it’s still a risk.

Inflation and Your Portfolio

We haven’t seen high inflation in a while, so it could be a tough environment for investors to navigate (you have to go back to 1996 to see inflation over 3%!). Luckily, we’ve got you covered.

Here are some sectors that could shine in an inflationary environment:

  • Consumer staples: Consumer staples companies, like toilet paper and toothpaste makers, usually perform better in inflationary environments because they’re in a good spot to pass on higher costs to customers. Think about it: You may be able to give up your Peloton subscription to save money, but you can’t exactly give up toilet paper (so you’ll pay the price for it).
  • Energy: Inflation is a boon for prices of commodities, such as oil. Energy stocks and their profits typically track the price of oil closely. Energy could be an especially interesting sector these days as post-pandemic travel plans start picking up.
  • Financials: Bank and insurance stocks tend to thrive when rates rise, a classic market reaction to higher inflation. Right now, we’re seeing this play out in Treasuries: The 10-year yield has risen 30 basis points since the beginning of November.

Outside of stocks, consider diversifying your portfolio in case stocks fall. Real estate, TIPS (Treasury Inflation-Protected Securities), and gold are assets that could help hedge against an inflation scare.

Bottom Line

Inflation is becoming a bigger theme for 2021, especially as the Biden administration contemplates this latest round of stimulus. That could be an obstacle for the stock market, especially if the Fed has to prematurely change course.

Right now, we’re watching for signs indicating if any rise in inflation could be temporary or permanent. If it’s just a quick shock, we may see some market weakness without any major Fed action. On the other hand, persistently high inflation may force the Fed to consider raising rates and pulling back its market support.

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Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.