Unexpected Inflation and the Stock Market: A revisit of a long-forgotten enigma
Abstract: As inflation has reached 40-year highs in the U.S., there is a new opportunity to revisit the relationship between the stock market and inflation. We first develop a theoretical valuation model based on a typical S&P 500 stock to benchmark the intrinsic value change one can expect when inflation increases by one percentage point. After establishing the benchmark impact, we measure unexpected inflation based on economists' forecasts and observe the one-day stock market response on the days when the U.S. Bureau of Labor Statistics releases its monthly CPI reports. We find no significant relationship between stock market returns and unexpected inflation for 2002-2022. However, we notice a shift in the unexpected inflation measure from 2021 onwards and find that, when observing post-2021 data only, the stock market responds negatively to unexpected inflation across different sectors. The S&P 500 responds by -6.1% for every percentage point of unexpected inflation. Contrary to common belief, real estate seems to be a poor inflation hedge as the Dow Jones Real Estate Index responds by -7.1%. The negative responses vary across the other sectors, with Consumer Discretionary responding most negatively by -8.3%, while Consumer Staples responds least negatively by -2.5%. Our results suggest that the market has not viewed new information about inflation as material for updating its long-term inflation expectations during 2002-2020, but only after 2021 when inflation started accelerating. While some sectors react less negatively to unexpected inflation, the results indicate that common stocks are unsatisfactory inflation hedges.
AT THIS PAGE YOU CAN DOWNLOAD THE WHOLE ESSAY. (follow the link to the next page)