A Little Inflation Isn’t Bad

04/01/2008 12:00 am EST

Focus: MARKETS

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, Standard & Poor’s chief investment strategist, says the Fed’s interest rate cuts may boost inflation a bit, but not enough to hurt equity markets in the long run.

The equity markets dodged a bullet when the Standard & Poor’s 500 recovered on March 18th from the Bear Stearns-induced sell-off of March 17th.

Following an early plunge in the market, the S&P 500 rallied by the end of March 17th to remain above the 1270 level, what we believe to be critical support. Investors likely looked upon the pending sale of Bear Stearns [to JPMorgan Chase] as one issue they can stop worrying about.

It probably didn’t hurt that the Federal Reserve backed the [deal] with $30 billion (subsequently reduced to $29 billion when JP Morgan raised the price to $10 a share), and then lowered the federal funds rate by 75 basis points at the March 18th Federal Open Market Committee (FOMC) meeting.

The committee indicated that further rate cuts could be seen, since “downside risks to growth remain.” S&P Senior Economist Beth Ann Bovino said a cut to 2% is likely. “Most Fed members feel that the Fed has to fight recession now, and worry about inflation later,” Bovino noted.

S&P Economics expects headline and core consumer prices to decelerate over the next two quarters. This implies a drop in oil prices from the record high of $111.80 a barrel reached on March 17th to an average of $91.33 by year-end. If oil continues to rise, the value of the dollar depreciates more than expected and productivity slows sharply, inflation would rise rather than moderate, she says.

While their forecast is for the consumer price index (CPI) to rise to 3.5% in 2008, up from the average 2.9% in 2007, [S&P economists] expect it to decline to an average of 2.1% in 2009. They also see the core CPI averaging around 2.6% through 2011.

Historically, the S&P 500 posted its strongest monthly advances during periods of modest increases in inflation (2.0%-3.9%), yet stocks came under pressure when the headline CPI’s rate of annual change rose above 4.0%. We believe, therefore, that the market may welcome a touch of inflation—but not too much—since slightly rising inflation implies that the economy is growing and producers are able to boost earnings through price increases.

During periods of accelerating inflation, investors traditionally gravitated toward the “real asset” areas of energy and materials, as well as the more defensive sectors of health care and utilities. S&P equity analysts have five-STARS recommendations on 90 stocks; 29 of these issues come from the energy, health care, materials, and utilities sectors.

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