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Will the S&P 500 crash next year over rising inflation?

The S&P 500 is up 25% over the past year as low interest rates combined with quantitative easing funnel money into US stocks. But this could soon change, as pressure to control rocketing inflation increases.

The S&P 500 is widely viewed as the best historical indicator of US stock markets performance, with the index returning roughly 8% per year between 1957 and 2018. And since collapsing to 2,305 points on 20 March 2020, it's risen 104% to 4,705 points by 18 November 2021.

But in the past two weeks, the S&P 500 has fallen to 4,577 points, as the impact of inflation, the Omicron variant, and recently reappointed Federal Reserve Chair Jerome Powell’s tapering comments have struck a nerve with some investors.

S&P 500: Inflation not so transitory

In July, President Jo Biden insisted that ‘most of the price increases we’ve seen are…expected to be temporary.’ And Powell has also been insisting that inflation is ‘transitory’ for some months now. However, giving evidence to the Senate Banking Committee on Tuesday, he said that ‘I think it’s probably a good time to retire that word.’ According to the US Consumer Prices Index, inflation is now running at 6.2%, its highest rate in over thirty years. And energy prices are up 30% over the past year alone.

His predecessor, and current treasury secretary, Janet Yellen, echoed his thoughts yesterday, saying that she is ‘ready to retire the word transitory…that hasn't been an apt description of what we're dealing with.’ And in an interview with Reuters over the impact of the Omicron variant, she said ‘there's a lot of uncertainty, but it could cause significant problems. We're still evaluating that.’ A key concern is that supply chain issues that are already causing port blockages and shelf shortages will be worsened by the variant.

Meanwhile, the Consumer Confidence Index decreased in November, from 111.6 in October to 109.5 in November. Worryingly only 17% of consumers think business conditions are good, while 29% think they’re bad.

And the President has just passed his $1.2 trillion infrastructure bill and is now pushing a $1.75 trillion ‘Build Back Better’ social spending plan. As the total US tax revenue for FY21 is estimated at $4.05 trillion, it’s safe to assume that money will have to be created to fund these new projects.

But dollar printing has been going on for some time now, with 18% of all US dollars currently in circulation printed in 2020. With inflation rising amid ambitious government spending plans, pressure is rising on the Federal Reserve to control the money supply. And this could hit the S&P 500 hard.

Faster tapering

Last month the Reserve started tapering back its quantitative easing program. Powell justified this decision due to ‘elevated inflation pressures, we've seen very strong labour market data without any improvement in labour supply, we’ve seen strong spending data too.’

In his testimony, the Federal Reserve Chair said ‘we are actually at our next meeting in a couple of weeks going to have a discussion about accelerating that taper by a few months.’ Having begun in early 2020, the program is currently slated to end by mid-2022. It's already added $4.5 trillion to the Reserve’s balance sheet.

However, Powell also sounded concern over the Omicron variant, saying that whether tapering is accelerated will depend on its ‘transmissibility, it's about the ability of the vaccines to address any new variant, it's about the severity of the disease once it's contracted.’ But if the Omicron variant doesn’t drastically cause cases to rise, then it’s safe to assume that monetary policy will soon be tightened.

The effect on the S&P 500 could be drastic. Less money entering the financial system could see its growth slow. And with inflation continuing to increase, an interest rate rise might be on the cards as well, hitting companies’ ability to expand through cheap debt.

While a S&P 500 crash is unlikely in the near future, it’s up 25% over the past year. A correction at some point next year wouldn’t be surprising. Of course, with so many moving variables, its bull run could also continue.

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