Stocks have been rallying in recent weeks on the hopes that U.S. inflation will continue to come down and that interest rate cuts may be around the corner. That, however, is by no means a certainty. But a lower rate of inflation would eventually lead to lower interest rates, which, in turn, would make growth stocks more attractive buys.
One portfolio manager who is optimistic about inflation coming down next year is Cathie Wood, whose Ark Innovation ETF (exchange-traded fund) is often viewed as a barometer for growth stocks. It's up 55% this year. But if Wood's expectations for next year prove accurate, then the fund could just be getting warmed up.
Could deflation happen?
Since shortly after the start of the pandemic, the Federal Reserve had been holding the benchmark federal funds interest rate at essentially zero. But about two years ago, in response to sharply rising inflation, the Fed began a series of rate hikes intended to curb inflation. Those hikes had the desired effect, but while inflation did ease, its decline has stalled in recent months in the 3% to 4% range -- still above the Fed's target of around 2%.
Wood, however, expects that not only will inflation continue to go down, but that it could even go negative at some point during 2024. A 10-year history of the inflation rate shows that periods of deflation aren't exactly unheard of, but they are rare.
US Inflation Rate data by YCharts.
When deflation last occurred, in 2015, it was brief. It was, however, a mediocre year for the S&P 500: The index was down almost 1%.
Winners and losers if inflation comes down sharply in 2024
A negative inflation rate appears unlikely, but if inflation comes down significantly in 2024, it could have varying consequences for stocks. Here's a look at the types of stocks that could benefit, and which ones may struggle.
- Interest-rate sensitive stocks: Winners. Upstart Holdings, which is sensitive to interest rates, could thrive in a scenario where an extremely low rate of inflation leads to the Federal Reserve slashing interest rates. Its lending platform, which utilizes artificial intelligence (AI) to help lenders make loan decisions, could benefit from an uptick in demand.
- Real estate investment trusts (REITs): Winners. REITs haven't been doing well this year as higher interest rates impact their ability to raise money, as well as raising their interest expenses. These businesses typically carry a high amount of debt, and a reduction in interest rates could make them more attractive investments.
- Big-box retailers: Winners. If deflation were to occur, retailers such as Walmart and Costco could benefit as they could acquire products for lower prices and improve their margins. As the rate of inflation starts to cool, these companies could use their pricing power to load up on goods in bulk, locking in even more cost savings before consumers expect to see them reflected on store shelves.
- Consumer staples: Losers. The types of stocks that could suffer the most in a deflationary environment are ones that have been hiking prices to offset rising prices. Grocery stores are a good example of this. Consumers are likely not going to eat more food just because prices are lower. Instead, if food takes up less of people's budgets, they'll have more to spend on discretionary items. If deflation occurs, their volumes may remain the same, but grocery businesses and other consumer staples companies will no longer benefit from being able to charge higher prices.
- Oil and natural gas stocks: Losers. Oil and natural gas companies have been doing well due to rising commodity prices in recent years. But this is a cyclical industry, and if there's another downturn in the industry due to a decline in energy prices, these stocks could quickly become unpopular investments.
Investors shouldn't put too much faith in forecasts
Regardless of what may or may not happen, investors shouldn't worry too much about any expert's specific prediction or macroeconomic forecast.
Billionaire investor Warren Buffett says he simply doesn't worry about such forecasts when he's making investment decisions because of how quickly conditions can change. And investors should expect volatility over the long term.
"When you get into economics, there's so many variables, and the truth is, you've got to expect good times and bad times in business," Buffett said during an interview last year with Yahoo Finance.
While it can be helpful to know what to expect in a deflationary environment, investors shouldn't radically change their investing strategies for something that may last for only a brief period, if at all.
Instead, the better strategy is to invest in quality businesses that should perform well in the long term, regardless of economic cycles. By sticking to stocks with strong fundamentals and pricing power, investors can maximize their odds for great returns in the long run.
