Inflation After the Peak: What It Means for Bonds and Stocks

You probably don’t need a chart to remember what inflation was like in 2022. (And looking at a chart could never capture the feeling of seeing gas, groceries, rent and almost everything else getting more expensive all at once.)

And you certainly don’t need a chart to tell you it hasn’t gone away. The data might say that inflation has fallen significantly since the 2022 peak, but let’s be clear: When inflation “falls,” prices usually aren’t going down. They’re just rising more slowly.

There are some positive things you can say about inflation overall: Sometimes it’s a signal of a growing economy. It can help push wages higher. But sticker shock just plain doesn’t feel good, and it probably never will.

For investors, inflation has another angle. The question isn’t simply what’s happening to the prices of the stuff you’re buying. It’s also how inflation cycles impact stock and bond returns. We’ll take a look at what answers we might get from history, but first, let’s review how inflation cycles usually play out.

INFLATION USUALLY COMES BACK TOWARD EARTH … JUST NOT ALL THE WAY

History gives us a surprisingly consistent pattern: Inflation tends to quickly drop after a peak, but a complete return to “normal” inflation can be a long time coming.

Annual inflation rates as measured by the Consumer Price Index.

The 2022 cycle is a good example. Inflation peaked at 9.1% in June 2022, then dropped sharply over the following year. That was a welcome relief. But instead of falling all the way back to the Federal Reserve’s 2% target, inflation settled closer to 3% and lingered there. (More recently, it’s even started to move higher again.)

Earlier episodes show the same general idea. After the inflation peaks of the 1970s and early 1980s, inflation declined significantly, but it took years to fully normalize. In some cases, it even showed the same pattern of reaccelerating along the way.

Markets don’t just care about the number in an inflation report. They ask (and respond to):

• Is inflation lower than it was?
• Is it coming down enough for interest rates to drop?
• Is it stopping consumers and businesses from planning and spending?

As we’ll see, those second and third questions, while they might not be the ones you’re wondering about as a consumer, are key to how inflation plays out in the bond and stock markets.

WHAT PERSISTENT INFLATION MEANS FOR BONDS

Bonds are where the impact of inflation shows up most directly.

Most bonds pay fixed interest. So let’s say you bought a bond that pays 3%. That’s what you agreed to accept in return for your investment. But like a salary you accept when starting a job, high inflation can suddenly make it feel like a whole lot less. The bond interest is just not worth as much to you as you thought it would be.

At the same time, inflation pressures central banks to raise interest rates. So your existing bond will be worth less price-wise if you want to sell it – newer bonds will be worth more because they’re paying more interest.

That combination matters because bond returns can come from two sources:

1. The interest payments you receive
2. The change in value (price) of your bond when interest rates change

Put them together, and you can see that bonds may not fare as well during bouts of high inflation. But what about afterward?

Historically, bonds have often delivered solid returns after inflation peaks (as always, you should remember that past performance doesn’t guarantee future results). The connection makes intuitive sense – if inflation is coming down, interest rates may be near their peak as well. When rates eventually fall, existing bonds can become more valuable because newer bonds won’t pay as much.

Bond returns after inflation episodes

Returns for two and three years represent average annualized returns for the Bloomberg U.S. Government Intermediate Bond Index following 1974 and the Bloomberg U.S. Aggregate Bond Index for later episodes. Past performance does not guarantee future results.

That’s what happened in most of these examples. But, as we mentioned, it’s not a guarantee.

The post-2022 period – you know, the one we’re currently in – illustrates this clearly. Bond returns haven’t been anything to write home about: lightly negative one year after the inflation peak and only modestly positive over the next couple of years. The reason isn’t that inflation didn’t fall – as you can see, it did. It’s that inflation hasn’t fallen enough to allow for meaningful rate cuts.

So “inflation has peaked” doesn’t automatically mean “bonds are about to see a big rebound.” Bonds tend to do best when inflation falls both far enough and fast enough for interest rates to drop. If inflation stalls at a still-uncomfortable level, bond returns may depend more on interest payments than on rising prices.

WHAT PERSISTENT INFLATION MEANS FOR STOCKS

Now, the relationship between stocks and inflation? It’s complicated.

On one hand, inflation raises costs: Wages, materials, shipping and business loans all become more expensive. Some companies struggle to absorb that – usually, the ones whose products and services don’t make it into belt-tightened consumer budgets.

Inflation can also do a funny thing to investor mindsets. If inflation is high, then interest rates are probably high too, and that can make investors prefer cash to stocks.

On the other hand, many companies can simply raise prices (hello, 2022). And revenues and profits can continue to grow even in a higher-inflation environment.

That’s why the historical pattern for stocks often surprises people: Stocks have frequently performed well after inflation peaks (which is, again, not a guarantee).

Stock returns after inflation episodes

Returns for 2 and 3 years represent average annualized total returns for the S&P 500.  Past performance does not guarantee future results.

Let’s go back to 2022. Despite widespread concern that high inflation and rising rates would derail markets, stocks recovered strongly after the peak. (For comparison, the average annual return for U.S. stocks over the entire 50-year period of the chart was about 13%.) Consumer spending held up better than expected, corporate profits remained resilient and new drivers of growth – particularly in technology and artificial intelligence – helped support returns.

PULLING IT TOGETHER: THREE PATTERNS

Across different inflation cycles, a few themes consistently emerge:

1. Inflation is persistent. It usually doesn’t stay at a peak for long, but it often remains higher than “normal” for quite a while.
2. Bonds can benefit from falling inflation, but it’s not a given. Fast declines that trigger interest rate cuts tend to support stronger returns.
3. Stocks as a whole can perform well post-peak (although individual companies may struggle). Even with imperfect inflation conditions, as long as the economy avoids a deep recession, markets have often moved higher (though they haven’t always followed the pattern).

BUT DO THE PATTERNS MATTER?

Patterns are interesting and can even be reassuring. The challenge, of course, is that in the moment, it’s impossible to know if the cycle you’re in is going to follow the pattern.

It’s difficult to know when high inflation will rear its head. It’s even harder to predict how quickly it will fall or how markets will respond along the way. Each cycle has its own combination of policy decisions, economic conditions and investor behavior.

But there are two things you can consider doing to have a better chance of building inflation resiliency into your portfolio, so you don’t have to worry as much about what inflation is up to:

• Own a mix of assets that is built to have a greater chance at outpacing inflation over time
• Diversify within each asset class so you’re positioned to take advantage of any inflation path (think of it as an “all-weather” approach)

In bonds, that means diversifying across maturities:

• Short-term bonds can hold up better when inflation is sticky and rates stay higher
• Intermediate-term bonds provide a balance of income and flexibility
• Long-term bonds can offer more upside if inflation falls quickly and rates decline

In stocks, it means diversifying across regions and sectors:

• Different kinds of companies hold up differently under high inflation and interest rates
• Different regions (U.S. and international) have different inflation environments, monetary policies and currency impacts
• A broader allocation gives more opportunity to benefit from whichever part of the market rebounds most and fastest

INFLATION WILL CONTINUE TO HANG AROUND

High inflation isn’t a one-time event. Over a long investing horizon, it’s something you’re likely to encounter more than once, along with recessions, rate cycles and bear markets.

We’re not getting rid of inflation, and your goal shouldn’t be to get rid of inflation risk. Instead, we focus our efforts on building portfolios that are designed to have a stronger chance of growing faster than inflation over time and that can be resilient enough to hold up across a range of economic environments.

Inflation will rise and fall. Markets will adjust. Investors who stay diversified – and avoid making big, all-or-nothing bets on what happens next – can be better positioned for whatever comes after the peak.