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Rising inflation is making headlines due to the increasing cost of fuel, food and other essentials, but how does inflation affect the stock market? Here we’ll explore this topic in greater detail to help you make plans for your long term financial health.
Why Is Inflation Rising?
Inflation is a measurement of the rate at which prices of goods and services within an economy rises. Inflation is on the increase around the world, but the U.S is experiencing the highest levels of inflation since 1981.
There are three main factors that are currently driving the increasing inflation trend.
The fallout from the 2020 Coronavirus Pandemic: The 2020 pandemic was not only a health situation, but it had a massive economic effect. The pandemic caused production facilities to shut down, shipping routes became clogged and businesses paused their activities. The U.S government provided a number of financial measures to help support the economy as business activities shut down. However, this has led to excess demand, triggering increasing inflation.
Energy Cost Issues: In recent months, the price of crude oil has climbed beyond $100 per barrel on several occasions. This has a direct impact on how much you pay at the pump. Bear in mind that transport companies also have to pay this higher price of gas, which triggers an increase in food and services. These energy cost issues have been exacerbated by the Ukraine conflict. The sanctions on Russia have created global market uncertainties about the potential supply disruption.
Rising Wages: Another factor in the inflation trend is the rising wages. The U.S is seeing rising wage rates throughout many sectors including food and agriculture. According to Bureau of Labor Statistics data, employment costs in the U.S have continued to accelerate and are now well above pre-pandemic trends.
How Does Inflation Affect the Economy?
Inflation affects consumers, companies, and governments in a number of different ways. These include:
- Reduced Purchasing Power: This is the primary and most obvious effect of inflation. As prices rise, it reduces purchasing power. While this is most noticeable for consumers, who see the prices of groceries and everyday items increasing, it can also affect businesses who need to pay more for their raw materials, further driving up prices as they need to compensate for the increased production costs.
- High Inflation Feeds on Itself: This point follows on from above. While a little inflation keeps the economy healthy, when it increases sharply, there are expectations of future inflation, creating a self fulfilling prophecy. Workers start to demand higher wages and employers pass on the associated costs by raising prices. In a worst case scenario, high inflation can lead to hyperinflation, where you need hundreds of dollars to buy basic items.
- Increases Interest Rates: Governments have incentive to keep inflation rates in check. The typical approach is to use monetary policy to manage inflation. So, if inflation is threatening to exceed the target levels, policymakers tend to raise the base interest rates. This drives up the cost of borrowing and restricts money supply.
- Lowers the Cost of Servicing Debt: Although new borrowers will face higher interest rates, if you have a fixed rate mortgage or your plan to get a loan, you will benefit from keeping the same repayments in the face of rising costs. When your payments are adjusted for inflation, you’ll see it costs less to service your existing debt.
- Promotes Short Term Growth: In the short term, higher rates of inflation can trigger faster economic growth. Since higher inflation discourages savings, consumers are encouraged to spend now and businesses are more likely to invest to offset the eroded purchasing power.
- Triggers Recessions: While there may be short term economic growth, high rates of inflation often leads to recessions. With price hikes, higher interest rates and other other effects of high inflation, unemployment starts to reach higher levels, which can trigger a recession, which affects consumers, companies and governments.
How Rising Interest Rates Affect Companies?
While higher interest rates can have a massive impact for consumers, they can also affect companies in a number of ways. These include:
- Lower Demand for Products and Services: Interest sensitive businesses will see a lower demand for their goods and services. For example, mortgage industry companies are likely to have fewer customers looking to refinance their homes. However, this effect can also be felt by companies that offer big ticket items that tend to require financing, as customers may be reluctant to pay the higher finance rates.
- Higher Borrowing Costs: Almost every company relies on finance to keep operating. Unfortunately, higher interest rates will not only mean higher borrowing costs, but also greater difficulty in obtaining finance. If a company has long term debts, any increase in the interest rate will mean that it will take longer to pay off the finance and the business will need to carry the debt longer.
- Decreased Profits: With static or potentially lower demand, companies will be unable to pass on any increased operating costs to consumers. This means that the company will need to deal with decreased profits that could reduce the amount of discretionary income available to expand business operations or move towards achieving future financial goals.
How Does Inflation Affect the Value of Stocks?
Superficially, in times of high inflation, the value of the company should be higher. Company shares are an asset and should provide an asset price increase. However, there is an opposing force. Inflation can hurt company revenues, which makes the company and its shares worth less.
For example, high inflation does increase the cost of borrowing, which can be detrimental to many companies, particularly those in the tech industry and start ups. When a company has less available capital, it can reduce the long term earnings estimates and therefore its value.
However, historically, investing in stocks does offer greater inflation protection, as it has the potential to outrun inflation. For example, the annual average S&P 500 index return is 10% higher than the annual inflation levels recorded in early 2022.
Please bear in mind that you may need to adopt a long term strategy, Stocks can be volatile, so you will need to perform due diligence to ensure that the stocks you choose meet your strategy criteria for investing. Every company has a different business model which will indicate whether they are more or less inflation sensitive.
As we touched on above, there are also different sectors that have greater inflation sensitivity. For example, a B2B business in a stable sector will be less sensitive to inflation compared to a B2C company offering luxury products.
Historical Performance of the Stock Market?
To fully understand the impact of inflation on the stock market, it is a good idea to look at other times in recent history when there was high inflation and high interest rates.
In 1977, the stock market went into a bear market, which ended the bull market of 1975 and 1976. During this time the S&P 500 index dropped approximately 20% before it bottomed out. This 20% decline in approximately one year does make this a fairly minor bear market, but it does show how the stock market reflected the high unemployment, currency uncertainties and business stagnation that occurred at this time.
We also experienced another bear market between 2000 and 2002. This was relatively minor compared to the market gains of the 1990s, but it did last almost 2 and a half years. During this period, the S&P 500 index dropped approximately 50% before it bottomed out.
However, when you look at a weekly chart covering this period, you will see the stock market did not go in a straight downward line. It created a bumpy line, showing declines and several small rallies, but these only lasted a month or so.
The final example of how the stock market performed during high inflation and high interest is a little more recent. In the 2008 bear market, trading bottomed out below the 2002 bottom, highlighting that this bear market was severe and today is referred to as the 2008 Financial Crisis. The bear market started in 2007 and lasted 17 months, with a drop in the S&P 500 index of 55%.
How Does Inflation Affect Growth Stocks?
Historically, growth stocks have dropped in price in high inflation periods. However, growth stocks are shares that demonstrate the potential to outperform future markets, since they don’t show strong current free cash flows or offer dividend pay outs.
Growth stocks are a long term investment and could provide worthwhile returns if they have the opportunity to mature. These stocks tend to consistently produce better than average returns.
It is worth considering discounting growth stocks to a present value, since the expected cash flows are ahead of time, the compounded discount rate may adversely impact the current share prices.
How Does Inflation Affect Blue Chip Stocks?
Blue chip stocks tend to perform better compared to growth stocks during periods of high inflation. This is because blue chip companies typically carry less debt. Since any increase in interest rates will drive up operating costs for companies that depend on debt fueled growth, blue chip companies can continue to operate with minimal disruption.
Blue chip companies are likely to provide a good pay off, whether the stock market is good or struggling under high inflation conditions. While these companies may not experience the same levels of growth compared to a low inflation economy, as they tend to carry less debt, they will only be impacted by any raw material price increases rather than the double blow of higher debt servicing costs and increased production costs.
How Does Inflation Affect Technology Stocks?
Historically, tech stocks tended to struggle in periods of high inflation. This is particularly important to note now, as over the past 10 years, tech stocks have been some of the strongest S&P 500 performers. Their big gains may mean that they may now account for a larger share of investor portfolios.
Tech stocks have delivered market leading performance, while inflation has been low, but tech companies tend to heavily rely on financing to fuel growth. This means that when interest rates rise and financing is more difficult to obtain, it can negatively impact this sector.
In the past, the faster the inflation rose, the worse the returns of tech stocks relative to the overall market. So if you are looking to inflation hedge your portfolio, tech stocks may not be the best choice.
How Does Inflation Affect Bank Stocks?
Banks are affected by inflation in different ways, which can impact on their stock performance. While the FED rate increases allows banks to increase rates and boost their margins, the threat of a recession can have a major impact on stock performance.
Banks tend to perform well during mildly increasing inflationary environments. However, when inflation becomes out of control, there is a great deal of uncertainty and consumer demand falls. This means that if a recession is looming, bank stocks may be a bad investment. When the housing demand drops and the demand for other financing products drops, defaults increase and savers look for alternative places to place their funds, banks can start to have serious financial difficulties.
In the last large high inflation period, in the 2008 financial crisis, many high profile banks had to rely on bailouts to continue operating, which had a devastating effect on stock prices.
Which Sectors or Companies May Benefit From Inflation?
There are several sectors that have historically benefited from higher inflation rates. Precious metals tend to have a high economic value, which can allow you to hedge against high inflation. Buying gold (especially physical gold) is often used as an alternative currency in weak economies. You just need to be aware that gold prices can wildly fluctuate, so it may simply be a good place to hold your funds, rather than make massive gains.
Another sector that may benefit from inflation is industrial metals. Metals such as copper, aluminum and lithium tend to demonstrate solid price appreciation. Lithium, in particular, is anticipated to experience solid growth regardless of inflation. Lithium is a key component to produce EV batteries and with the increasing demand for greener energy, this industrial metal is likely to continue to increase in value.
Finally, energy sectors tend to move closely with the rate of inflation. Energy is an essential for every economic sector, so they are required even if the prices skyrocket.
Does Inflation Affect Bonds?
Bonds offer investors two potential avenues of returns; interest payment and increase in the bond value. Unfortunately, inflation can impact both of these return possibilities. Inflation erodes the purchasing power of the bond’s future cash value and reduces the real value of your interest earnings.
For example, a bond that pays 6% yield may seem very attractive, but when inflation is at 5%, your real return is only 1%. Since bonds are fixed term investments, you cannot make adjustments if the real return becomes unattractive. If you try to liquidate early, the cash out value will be far less than the value. So, if you tie your money up for several years, when inflation is high, you may be disappointed at the maturity value.
However, there is one area of the bonds market that will weather high inflation conditions. TIPS (Treasury Inflation Protected Securities) are U.S government guaranteed bonds that provide an effective way to offset the risk of inflation. When inflation increases, the TIPS principal value is adjusted upward and when inflation drops, the value is adjusted down.
How to Invest During Inflation?
The main challenge to investing during high inflation is determining the real value of the returns. Before you commit to any asset, you need to think about the context of the return in terms of what purchasing power it can offer. You will also need to look at how assets and sectors have performed during previous periods of high inflation.
Investments can behave very differently in a high inflation environment and if you only have experience investing when inflation is low, you may have to make radical changes to your investment strategies. This may mean adopting a less risk averse approach to achieve the returns that you previously could expect when inflation was low.
1. Previous Metals, Tangible Assets
Tangible assets such as precious metals tend to offer the best hedging tool. As long as inflation is higher than FED rates, these assets tend to hold their value. Investors tend to favor precious metals such as gold coins and gold bars, silver andduring high inflation as they are likely to benefit from the rising prices.
Tangible commodities tend to be raw components for consumer products and can be necessary for B2B companies, so even when the prices increase, the demand tends to remain fairly stable.
Other tangible assets that tend to do well in high inflation are energy related products. Companies that offer oil and gas tend to be strong performers even in high inflation.
2. Stocks, Real Estate and Bonds
These types of assets tend to be more risky as there is greater potential for a downturn. We’ve already discussed stocks and bonds, but the real estate sector can be particularly inflation sensitive. While high inflation can provide greater rental income due to the increasing cost of living, it can have a detrimental impact on real estate investing.
When inflation is low, people tend to have more disposable income, so they are more likely to upgrade to a larger home or purchase a first home. However, when rising inflation is apparent in the cost of essentials, people tend to be less inclined to make a larger financial commitment. This is exacerbated when the FED increases interest rates. Potential buyers are then confronted with higher borrowing rates.
The reduced numbers of buyers means that demand is outstripped by supply, which can lead to a drop in property prices.
While it may be possible to still find good real estate investments, you need to assess the risk of negative equity, where the value of the property drops below how much you paid for it. This was evidenced in the 2007 housing crash, where the property bubble burst and left many people in financial difficulties.
3. Savings Accounts/CDS and MMAs
These tend to be safer types of investments, but you still need to consider the long term implications. Higher inflation may be seen as a positive thing, as savings, CD and MMA customers can enjoy higher interest rates. When the FED adjusts the interest rate to address rising inflation rates, banks follow suit and adjust their rates. This means the rates for both lending products and deposits go up.
However, the negative side of this is that the deposit rates may still be less than the inflation rate. For example, if you had $100 in your savings account, at the time you made the deposit, this amount could have purchased 30 gallons of milk. After one year, the same $100 may only be enough for 25 gallons of milk.
You need to consider the fixed real value of your deposit rate. However, if you do want to keep your investments very conservative, it is possible to balance this with short term CDs . You could obtain a decent rate with a short term CD, which while it may not be as high as longer term CDs, you can liquidate and reinvest to adjust for the changing rates. You can always deposit your money on one of the best savings accounts.
There is a strong relationship between interest rates and inflation. When interest rates are rising or falling, it can affect inflation and whether the economy is susceptible to recession. Typically, inflation and interest rates move in the same direction. This is because interest rates are a tool used by the U.S central bank to manage fluctuations in the levels of inflation.
If inflation is on the rise, the Fed increases the benchmark federal funds rate, which increases borrowing costs. The higher interest rates discourage business and consumer spending, particularly on big ticket, commonly financed items, such as capital equipment or housing. Increasing interest rates can also signal a likelihood that monetary policy will continue to be tightened by the central bank. The effects of interest rates increasing can curb rising inflation, allowing it to fall back to within the target rates.
However, this manipulation is not a perfect science. Policymakers respond to changes in the economic outlook, but there is a lag for policy changes to be implemented. This means that policymakers need to anticipate future inflation trends when they are deciding on present rate levels.
This does create the possibility for policy error if by anticipating inflation risk trends they needlessly increase rates and stifle growth or fuel inflation rates by setting the interest rates too low.
Inflation is typically measured every month. The cost of thousands of everyday items is assessed to calculate the rate at which the prices are increasing. The FED aims to manage periods of high inflation to avoid the country falling into a recession.
However, where inflation tends to settle and how long periods of high inflation last depends on the FED and the tolerance of the American public. There are economists and industry experts who predict that this period of high inflation is set to last longer than the pandemic spike.
The reason for this is that there is a catalog of reasons behind the increasing inflation, including the 2020 pandemic, environmental policies, the conflict in Ukraine, and more. Since there is not one simple measure that can address these underlying issues, it may take longer for FED policies to rebalance the rate of inflation.
Inflation is a reflection of increasing prices, so it means that your dollars simply don’t go as far as they did when inflation was lower. You may notice this when you visit the grocery store. While you may have been able to buy a carton of milk for $2 last month, when inflation is on the rise, that same carton of milk may cost $2.50 or $3. This means that while you may still be earning the same salary, it will not be able to buy as much as you could previously.
Most consumers will notice the impact of high inflation with their everyday spending. You may notice that the cost of your grocery cart is now higher or it costs more to fill your gas tank.
However, inflation impacts almost every aspect of the economy. Companies will need to pay more for raw materials and services. As a result, these companies need to pass on the increased production costs by increasing their prices.
This means that you can expect to pay more for your everyday essentials, big ticket items and even services.
There are benefits and drawbacks to purchasing actual gold or gold stocks. Stocks of gold, for instance, are speculative. They trade similarly to regular stocks. Their costs change in response to market conditions. In other words, they adopt current market trends. Even when the price of gold bullion declines, they can still perform noticeably better than actual gold.
Contrarily, the price of physical gold increases during economic downturns. They are profitable because of the gold rush to protect investors from the current market catastrophe.
Additionally, even if the underlying price changes, the inherent worth remains constant because you own them in your hands. But exercise caution. The cost of storage will add up if you don't store your gold bullions alone. Additionally, they draw custodian fees for insurance and gold IRAs.
Mutual funds do, in fact, carry modest risks, but they also produce low to medium yields. The drawback is that they have greater fees than equities. Stocks, in contrast, carry higher risk, but they may also offer moderate to large rewards. Their investment has implications for business ownership. In other words, as the corporation becomes a giant, so do the shares.
A mutual fund's fund managers are not required to buy shares. To protect investors from risky situations, they diversify the portfolio using bonds or other debt products.
As an investor, you must weigh your income target against your risk tolerance. Generally speaking, a mutual fund is preferable if you have a low tolerance for risk. Invest in stocks instead if you want a larger return without worrying about the danger.
When you spot a stock that is about to crash, the procedure starts. After that, talk to your broker about borrowing these shares so you can sell them at the going market rate.
When the market fits the requirements, you purchase equities at a discount to achieve your return objectives. Last but not least, return the borrowed stocks to the broker, pay any costs, and benefit from the sales. In this instance, the profit is the difference between the selling price you borrowed and the price you actually paid for it.