Stocks closed out Friday’s session mixed at the end of a choppy week. The S&P 500 logged its first weekly loss in three weeks. The Nasdaq outperformed against the other two major indexes as the rotation into cyclical stocks and away from some high-growth tech names continued. Fears of inflation may be at work amid concerns that if all the stimulus being pumped into the financial system works, that could begin pushing up prices. In anticipation of higher inflation, there was broad based sell off in the bond market, with yields on the 10-year Treasury note climbing. Expected inflation  which stood at just 0.50% last March, got as high as 2.24% this week.

It is widely expected that inflation will be the next catalyst for a correction in the stock market. But is it the right way to think about inflation? The bears will tell you that higher inflation means future earnings will have to be discounted at a higher rate as such bringing down valuation of the company and hence, its stock price. But, the bulls will contend that corporations will be able to charge higher prices when inflation is higher implying that earnings will be higher in future years than they would have been otherwise. Who is right?

Future Wealth’s View

There is a concept in economics called “inflation illusion”. It is a lopsided view that inflation reduces future earnings but conveniently leaves out the positive impact to future earnings. And so, in periods of declining inflation, investors drive the market to higher valuations and in contrast, in times of increasing inflation, investors look for declining valuations.

In the end, inflation should not have any meaningful impact on equity valuations but that is not going to stop investors from being irrational. And so, it would be fair to expect that the stock market will likely struggle to move higher as the prospect of rising inflation gets digested. But, investors would be wise to pay attention to continued low interest rates, elevated consumer spending as vaccine rollout proliferates and finally, massive government support through the $1.9 trillion stimulus. All three, in principle, should provide support to a rising stock market.

Given this backdrop, when the opportunity presents itself, it would behoove one to be a rational investor who takes advantage of the opportunity to pick up stocks at lower valuations.