Search popularity for the word “inflation” grew 344% over the last year. This increase in traction shows that people are talking and listening a lot about inflation. How does it impact our lives as consumers and investors?
We know that inflation increases the cost of living, but it impacts the stock market, too.
TL;DR
- How do stock prices react to inflation? Historical data is contradictory. Factors include the current economic cycle, geographic region and level of risk.
- High inflation periods can inflate earnings reports since the value of a dollar is lower.
- The real rate of return can help you analyze your profit adjusted for inflation.
- Fixed-income securities like bonds, money markets, and CDs suffer the brunt of inflation the most.
- Staying in the market for the long-term with a diversified portfolio gives investors a much higher chance of retaining (or growing) their asset’s value amid inflation, especially compared to cash and savings accounts.
How to tell when inflation is high
There are numerous indicators of inflation, but the most straightforward one is the Consumer Price Index (CPI) report from the U.S. Bureau of Labor Statistics. The price for all items rose 0.8 percent in April 2021. This compounds for a 12-month increase of 4.2 percent.
Do stock prices rise with inflation? It depends
The historical data on stock prices and investment returns during high inflation periods is contradictory. It depends where the investments are from, how much risk is involved, and what part of the economic cycle the inflation period is in. As of Q2 2021, the United States is in the mid-cycle phase of economic expansion, which means growth is expected to continue until eventual contraction (aka a recession).
Stock prices during inflation also depend on the company the stock represents.
Some companies fare well with inflation. Businesses that have the privilege of increasing their prices in tandem with inflation feel a smaller impact on their bottom line. Even then, higher earnings don’t bring as much value when inflation takes hold (because a dollar is worth less), but the numbers look pretty on earnings reports. Not every company has the luxury of increasing their prices, in which case earnings won’t look as good.
Even when a company’s stock price stays steady or increases, the underlying value of that share could be slimmer.
Think of it this way. Just because the price of a tube of toothpaste increases with inflation doesn’t necessarily mean the price of a stock will, too. Often, you’re getting “less for more” where your stake in the company is the same, but that company’s value is not.
Income-driven securities like dividend stocks are more susceptible to volatility during inflation periods. This could mean lower prices and, ultimately, a slower rate of growth for stocks with high dividend yields.
When inflation lowers, public company earnings do, too
Historically, inflation rates don’t stay high forever, but it’s hard to tell how long the economic check and balance will last. Revenue and earnings in publicly traded companies tend to decrease along with drops in inflation.
Remember how we talked about inflated earnings reports? Once economic inflation wanes, those revenue and earnings metrics are no longer inflated. However, it doesn’t necessarily equate to a loss in value since lowered inflation means the dollar goes farther.
Looking at “real returns” to help us understand how investments perform during inflation
Real returns are a stock’s annual profit percentage adjusted for inflation. Instead of looking at actual returns, which may be a higher percent, you can adjust for inflation to see how the market is really doing.
Equation for real rate of return
Inflation impacts fixed income securities the most
Periods of high inflation negatively impact the value of a dollar now. This means that fixed-income securities feel the brunt of things. Fixed-income securities include:
- Bonds
- Certificates of deposit (CDs)
- Money markets
- Preferred shares
Often, people in retirement receive a fixed rate of income from these types of securities. When that income comes their way, inflation can dig into its purchasing power. Ultimately, this means receiving less value for the same premium.
In this case, keeping some assets in stocks even in older age is a form of hedgingor offsetting the risk that fixed-income securities carry during times of high inflation.
Why are tech stocks at the core of the inflation sell-off?
Premium investors are often worried about short-term returns. Since volatility is inherent during inflation, the outlook for returns looks modest.
“The fact that inflation and interest rates are on the way up, I think we have to recognize that returns overall in the U.S. equity market from this point will be very modest and perhaps volatile compared to what we have enjoyed especially over the last 12 to 15 months.” – Abby Joseph Cohen, Senior Investment Strategist at Goldman Sachs
How the government uses interest rates to manage the stock market and economy during high inflation periods
The Federal Reserve controls America’s interest rates. They use these interest rates as a tool to fight economic events like inflation.
When short-term interest rates increase, it becomes more expensive to borrow money. This is the Fed’s way of removing extra capital from the stock market.
Why does this work? Because inflation is defined by “too many dollars chasing too few goods.” This is known as demand-pull inflation. When the Fed takes money out of the economy, they’re also taking money out of the stock market, which helps to quell consumer prices.
Short-term interest rates went down earlier in 2021 but are beginning to ramp up again.
Well-diversified portfolios weather inflation better
“We don’t know if higher inflation is temporary or long-lasting, so having a diversified portfolio, which can hold up under different market environments, is key.” – Rachel Sanborn Lawrence, Lead Financial Planner for Ellevest
How will your particular investment portfolio fare during times of high inflation? It depends on what country you live in (because monetary policy is a huge factor) as well as your ability to hedge.
Hedging means using alternative investment strategies to offset your risk during volatile periods. Not everyone has enough money or knowledge to hedge with, but those that do are more likely to retain their value even when the stock market struggles.
Despite major sell offs from inflation fears, inflation is not in and of itself a cause for exiting your positions. In fact, your diverse assets are more likely to retain their dollar value during periods of high inflation when you invest them as opposed to saving them as cash or cash equivalents. The same cannot be said for high-yield savings accounts, especially when the federal interest rate shrinks annual percentage yields to a much less attractive rate.
In short, if you want your money to keep up with the times, investing makes sense.
Bottom line
Inflation signifies a recovering economy after periods of crisis. In a way, it’s like the light at the end of a tunnel. But it’s difficult to know when high inflation rates will end, since these periods can be long or short.
By diversifying your stock market portfolio and adjusting your risk in accordance with your time horizon, you’ll be better equipped to weather most economic eventsincluding inflation.