Fed’s new inflation strategy will lift profits and reduce risks for stock investors, Goldman Sachs says

  • The Federal Reserve’s new target of averaged-out 2% inflation should create a favorable environment for stock market participants, Goldman Sachs strategists said Friday.
  • Investors tend to fear rising inflation, but price growth will lift earnings in the near term by driving faster revenue growth, the team said.
  • The central bank’s updated target suggests inflation will run above 2% to make up for periods of slow growth. Accordingly, inflation-related headwinds should only emerge “near the new target inflation rate,” Goldman said.
  • Value and cyclical stocks are already expected to outperform once economic activity rebounds, yet Goldman also sees the Fed’s “lower-for-longer” interest rate policy aiding growth names that benefit from near-zero rates.
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Investors fearing that rising inflation will eat away at stock market gains need not worry. If anything, they should scoop up more shares, Goldman Sachs said Friday.

The surging US budget deficit, accommodative monetary policy, and potential for another stimulus bill have market participants girding for a jump in inflation. Price growth trended below the Federal Reserve’s 2% target for years before tumbling even lower during the coronavirus pandemic.

The most common concern among stock investors is that a return to 2% inflation could push interest rates higher and drag on stock prices, the team of strategists led by David Kostin said. Yet the bank expects the Federal Reserve’s overhauled inflation strategy – which targets an averaged-out 2% rate – will serve as a near-term boon for stocks.

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For one, rebounding inflation supports stocks by propping up earnings. Climbing prices fuel faster revenue growth and healthier margins. Stocks and commodities tend to outperform other assets when costs are rising, as well. Couple that trend with $222 billion in outflows from US stock funds and $855 billion in inflows to money market funds, and equities are positioned for a mass influx of investor capital, Goldman said.

“If inflation continues to rise, the rotation towards equities away from cash will likely persist,” the strategists said.

Inflation’s positive effect on stocks won’t last forever. Once price growth nears its target, investors typically trim stakes in preparation for central bank rate hikes. However, the Fed’s new target signals policymakers will let inflation climb above 2% to make up for recent periods of weak growth. Market headwinds will then only emerge “near the new target inflation rate,” Goldman said.

Recent indications of near-zero rates lasting through 2023 also buttress stock prices, the team added. Maintaining a low-rate environment keeps borrowing costs at historic lows through the US economic recovery.

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Goldman expects the Fed to hold off on raising its benchmark interest rate until 2025, as lingering labor market pain suggests full employment will take years to reach. Inflation will similarly struggle to reach target levels in the near-term. The bank expects core inflation to climb to 1.48% this year before falling slightly to 1.41% in 2021.

The “lower-for-longer” environment stands to boost several corners of the market, the strategists said. The Fed’s new strategy eliminates much of the risk growth stocks experience from rising inflation. Since the segment’s valuations hinge significantly on future cash flows, interest rate changes can slam prices. The central bank’s plan to hold rates low for years reduces that risk for growth names, the team said.

The growth-friendly backdrop doesn’t diminish value stocks’ near-term appeal, the bank added. Economic growth is poised to accelerate as the US reopens and leaps out of its recession. Companies that rely the most on economic activity will likely see earnings climb to pre-pandemic highs. Inflation’s effect on nominal interest rates and materials prices should aid financial and commodity-exposed stocks even more once price growth swings higher, the bank said.

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