Public companies have one overarching legally-mandated goal: maximize shareholder value. Of course,...by Jonathan Anthony
How Does Inflation Affect the Stock Market?
Inflation influences all segments of the economy in some way. Consumers feel the pain through their everyday expenses, and businesses see their own costs rise. But for investors, inflation is more complex than just rising prices.
That’s why investors need to know exactly how inflation affects the stock market and, in turn, their portfolios.
What is Inflation?
Inflation is when prices increase throughout an economy over time. As prices rise, the buying power of consumers – or the value of the dollar – goes down.
That’s nothing unusual since inflation is always with us to a certain extent. It’s the rate of inflation that economic experts keep a close eye on.
The normal inflation rate is around 2% or 3%, a rate measured through the core personal consumption expenditures price index (PCE).
Anything higher indicates that consumer demand for goods is outpacing the supply of goods available, leading to higher prices for almost everything.
Inflation can also be too low; there’s little demand for goods and services which slows the economy, keeps wages down, and sometimes leads to a recession and high unemployment.
It is the balance of supply and demand that determines the rate of inflation.
Here are the types of inflation an economy experiences:
Demand-pull is the most common type of inflation. It results when the demand for goods overtakes the supply of those goods and sends prices higher.
Costs for everything from grocery items to new cars and homes become higher than usual, and some goods can even become scarce because people are buying up everything.
Cost-push inflation results from a disruption in the supply of goods. The demand for things remains constant, but something occurs to keep those things from getting to potential buyers.
A war or pandemic are examples of things that can happen to interrupt the supply chain. They can clog up shipping and keep all sorts of goods from getting to their destinations.
Built-in inflation by itself generally reflects a normal economy. Wages stay in line with the cost of living, and the inflation rate is usually at the target of about 2%, where steady economic growth occurs.
Inflation and Interest Rates
The Federal Reserve Board monitors inflation and attempts to control it by adjusting the interest rate or cost of credit.
When inflation rises at a higher rate than the Fed thinks is good for the economy, they increase interest rates to reduce inflation or at least slow the inflationary rate.
When the interest rate goes up, it becomes more expensive for businesses and consumers to borrow money, making them more hesitant to purchase as much.
The interest rate has a significant influence on the stock market. That’s why traders react swiftly to periodic Fed announcements of changes in interest rates.
When the Fed announces an increase in the interest rate, the market generally dips. Traders react kindlier to a lower interest rate or no change in the rate at all.
So, the relationship between inflation and interest rates means that inflation has at least an indirect impact on stock prices.
Inflation’s Impact on the Stock Market
Besides causing changes in the interest rate, inflation can have other effects on the stock market. The market likes a normal, steady inflation rate where the value of the dollar is stable, supply and demand are in line, and the economy rolls along at a predictable pace.
But when inflation rises at a higher-than-normal rate, uncertainty sets in, and the market becomes more volatile.
When inflation is too high, people don’t buy as much, and businesses suffer because their costs rise in the face of stagnant sales.
Companies can correct this by relaying their higher costs to consumers through higher prices on what they produce. But that takes time to take effect, and stock prices suffer in the meantime.
The general rule is that high inflation is bad for the market. Some stocks are more resilient than others.
Value stocks with good cash flows and slower growth trends tend to hold up a little better, while growth stocks of faster-growing companies are likely to suffer the most.
There’s good news to all of this:
Inflation Eventually Passes
When inflation finally peaks, there are profits in the market. Since 1950, the S&P 500 has recorded an average return of 13% during the 12 months that followed 13 major inflation peaks.
There Are Good Stocks
History tells us that energy, consumer goods, financials, and utilities are types of stocks that can be gainers during inflation.
The Market Adjusts
During extended periods of inflation, businesses and consumers become acclimated to higher prices and ease back into buying stocks.
Stocks Are a Good Long-term Hedge
Companies’ profits should grow with inflation after a period of adjustment.
You Do Have Some Control
Inflation can be complex, but if you look closely at your portfolio during an inflationary period, you can identify investments that hold up best. You can use that information to put your money in better places.
Stay Vigilant When It Comes to Inflation
Because high inflation tends to drag the market down, it can leave investors feeling helpless. But you can battle back by being vigilant.
Keep a close eye on how inflationary trends affect your investments and reap the dividends from that knowledge in re-tooling investments and planning for the future.
StockMarketEye is a perfect service for checking the market and keeping your portfolio’s reaction to inflation in check.
Stock Market Inflation Effect FAQ
Yes and no. Stock prices may rise when consumer prices do, but generally, the market suffers from long periods of high inflation.
Some stock prices may rise with inflation, but most companies experience lower revenues when consumers cut back on their spending. That sends stock prices lower.
Inflation can be good for stocks because it exposes some stocks that can’t hold up and reveals the most resilient stocks during tough economic times.
Most stocks take inflation hard, but value stocks tend to do better. They are seen as bargains compared to more prominent growth companies. Stocks in sectors such as energy, consumer staples, financials, and utilities can perform well.
You can invest in stocks during inflation, but proceed with caution and watch your portfolio closely. Setting up a well-diversified stock portfolio can be a good hedge in the long run, anyway. But many investors turn to commodities such as gold as havens during long spans of inflation.