Inflation To Sink S&P 500: Brace For Impact?

The Fed and Chair Powell all but finalized last week – rates are unlikely to be cut in the Fed’s December meeting. Inflation risk isn’t gone yet.

We believe Chair Powell’s Fed sees inflation as a real risk – no – a massive threat due to possibility of persistent, sticky inflation – the kind that resulted in an almost 50% drop in S&P 500 from 1972 to 1974 (see Market Crashes Compared).

How much will that hurt? Well, the combined market cap of S&P 500 constituents is roughly $45 trillion. So a 50% decline in the index would mean a loss of more than $20 trillion in value. And you thought the $2+ trillion wipeout the benchmark index witnessed in the first 3 days of August was bad!

To make matters worse, persistent inflation combined with high interest rates hurt smaller companies the most – magnifying the impact on the small caps index Russell 2000. (Do you know how the Trefis HQ strategy, which has outperformed S&P, works with downside protection?)

Why is that?

3 ingredients: 1. Tariffs. 2. Deportation. 3. Low Taxes. In combination, this is a combustible mixture that’ll make it difficult for the Fed to fight an inflation spike in coming months, and running into 2025 as the Trump presidency kicks off.

The rules are simple. Higher tariffs will take cheaper goods out of the market. Prices will rise.

Mass deportations of illegal immigrants sounds reasonable – after all, they’re illegal immigrants – except it’ll make cheaper labor unavailable. On average, the price of services will go up.

Now while tariffs and deportations constrain supply of goods and services to increase prices – reduction in taxes makes more cash available. So people can spend more while prices are higher. High consumer willingness to pay, will lead to higher prices – fueling yet higher expectations for prices. Result, spiking inflation.

So what can anyone do to control the spiking inflation?

The Fed will pull out its 2022 playbook that it never got a chance to really put away: it’ll have no choice but to increase interest rates – not just reverting some of the recent cuts, but in fact, going beyond, to rates above 6% and even 7% or higher for short term treasuries! Now if you can get a guaranteed 6% on a 1-year treasury bill, or bank savings, a risk-free investment – won’t you demand a higher earnings and return from stocks as well?

Of course.

So what?

There will be an exodus – a massive outflow from the S&P and overall from risky equities into treasuries, CDs, and savings accounts. It happened in 2022 – within months, the S&P 500 tumbled by -20%. Easy to forget that Nvidia had lost more than -50% in 2022 alone, and trillions had been wiped from the market cap of Alphabet, Microsoft, and Meta with each tech giant seeing a drop of  40% or more. Smaller firms, with less cash on their balance sheets did even worse.

The difference is, in 2022 inflation was brought under control – Covid-related stimulus was a transient cause of 2022 inflation. This time tariffs, tax cuts, and deportations, together are likely to prove a stronger force – a more persistent force.

And then, there is the ticking federal debt bomb…

JPMorgan CEO Jamie Dimon recently raised a big red flag about the now $1 trillion in annual interest payments the U.S. owes on its debt. This is unprecedented. It is uncharted territory. And a higher interest rate on treasury securities only means even higher interest payments. The last thing investor sentiments can take during weak market conditions is a possibility of the U.S. defaulting on its debt. Things could unravel very quickly under such a situation.

… besides a real risk of commercial and consumer loan defaults

All market crashes happen because someone can’t pay back their loans.

For one, commercial real estate has been suffering for a while, Covid’s work-from-home gift was a big curse for the Retail and Office real-estate sector. In addition to an altered demand landscape, commercial real estate loans maturing near-term continue to face high rates and tough refinancing conditions. Things could break – especially if the Fed is forced to hike interest rates.

And then, there is consumer defaults – personal loans, auto loans, and credit card loans in particular. That makes banks like JPM, Citigroup, and BofA with large credit card books vulnerable (How low can JPM stock go in a market crash?).

This isn’t going to end well.

Here’s a question.

When things are bad, what do you expect Trump to do? Blame everyone else, or change his course on taxes, deportation, and tariffs?

We’re certainly hopeful his cabinet and loyalists will be able to sway his view into easing inflationary policies in the event they create spiking inflation before the U.S. economy plunges into a recession. But if the easing does not materialize or comes into play too late, how bad can things get if there is another recession? Our dashboard How Low Can Stocks Go During A Market Crash captures how key stocks fared during and after the last seven market crashes.

Invest with Trefis Market-Beating Portfolios
See all Trefis Price Estimates