The second-strongest bull market in history may be about to hit a wall as inflation ticks up, a feat that in the past caused stocks to underperform, according to Jefferies. "Higher inflation has not been a good thing in the past for equity markets, as performance generally weakens as inflation rises. A faster pace of rising inflation could bring about more rate hikes, which also weakens returns," Ward McCarthy, chief financial economist at Jefferies, wrote in a research note. In a study released Thursday, the investment firm analyzed the market's performance going back to 1948 versus measures of inflation and found an inverse correlation between the two variables. "As inflation ticks higher, small, mid, and large [cap companies] tend to weaken and vice versa. Inflation heading higher means that interest rates should also rise, and thus valuations for equities falls," McCarthy wrote. In a relatively short period of time, Jefferies says inflation has climbed higher and could continue on its uptrend through the rest of the year. CPI & PCE Deflator, YoY% Change Source: Jefferies "Inflation has been uber low in the last few years due to a number of reasons with the biggest being the sharp drop in commodity prices. However, more recently, we have seen the CPI [consumer price index] tick up to 2.5% and the Fed-followed PCE [personal consumption expenditure] at 1.9%," McCarthy wrote. By the third quarter, Jefferies predicts the CPI could peak at 3.2 percent and hover around that level thereafter. Among the areas of the market expected to be impacted the most, Jefferies analysts point to the specialty retail sector. "An accelerated pace of sustained Fed rate hikes due to higher inflation has the potential to curb consumer spending and subsequently hurt retail stocks which tend to be 'early cycle,'" equity analyst Randy Konik wrote. He says the potential for higher interest rates could also put a cap on the amount consumers borrow for large purchases such as houses and cars. "We do not believe a single rate hike will change the mindset of most consumers, but a consistent pace of increases has the potential to impact adjustable-rate mortgage loans, variable-rate credit cards, auto loans, small-business loans and private (not Federal) student loans," he said. Given the likelihood for consumers to refrain from making large purchases, Jefferies advises clients to stick with off-price retailers. "We continue to acknowledge the strength of off-price retailer fundamentals, aided by increasingly value-conscience consumers who have driven consistent increases in foot traffic. Looking beyond relatively fair valuations in our opinion, the potential for further increases in wages has been a key reason for our caution on the off-price retail space," Konik wrote. He points to Ross Stores and TJX as two of his favorite picks. He also likes Nike and Foot Locker because of their pricing power.
