High US inflation may cause headwinds for stock market: Capital Economics

RIYADH: The annual inflation rate in the US hit 6 percent in October, its highest level since the 1990s. While Capital Economics, an economic research company, does not expect it to stay at this high level, it still believes that inflation will remain relatively high, hampering stock market returns.

The London-based company does not share the bleak opinion that this high level will correspond to negative returns such as was the case in the 1970s. Yet, investors seem to be understating the inflation risks on the stock market, thinking it will drop in the coming period, the firm indicated.

Capital Economics believes that inflation will hover around 3 percent in the coming decade, which could be a cause for trouble for the stock market. This will be through three main mechanisms.

First of all, the research firm thinks that wage inflation will be persistent, pushing corporates’ profit margins down, setting back returns.

Secondly, since inflation is set to be around 3 percent, this will still prompt the Federal Reserve to introduce further monetary tightening. Currently, investors seem to be discounting very little tightening as they expect inflation to decline considerably in the next period. 

However, when investors start to discount more tightening, this will cause weaker equity returns.

The third channel through which the 3 percent inflation will inhibit stock market returns is through the rise in equity risk premium, which is currently low. The latter is the excess return earned by an investor when they invest in the stock market over a risk-free rate.

Again, persistent inflation will prompt investors to review their assessment and a higher risk premium will cause a drop in the stock market valuation.

Current account deficit

The US current account deficit surged to a 15-year high in the third quarter amid a record increase in imports as businesses rushed to replenish depleted inventories to meet strong demand, reported Reuters. 

The Commerce Department said on Tuesday that the current account deficit, which measures the flow of goods, services and investments into and out of the country, accelerated 8.3 percent to $214.8 billion last quarter. That was the largest shortfall since the third quarter of 2006.

Data for the second quarter was revised to show a $198.3 billion deficit, instead of $190.3 billion as previously reported. Economists polled by Reuters had forecast a $205.0 billion deficit last quarter.

The current account gap represented 3.7 percent of gross domestic product. That was the largest share since the fourth quarter of 2008 and was up from 3.5 percent in the April-June quarter.

Still, the deficit remains below a peak of 6.3 percent of GDP in the fourth quarter of 2005 as the US is now a net exporter of crude oil and fuel.