It’s no secret that inflation has been rising across the globe, a reality that the current conflict in Ukraine is only exacerbating. After years of low interest rates and manageable levels of inflation, there is a whole generation of investors who have never experienced investing in an inflationary environment and may not understand exactly what it entails.
So, how does inflation affect stocks? Is there any relationship between inflation and stocks? Let’s take a look.
Table of Contents
What Is Inflation?
First and foremost, besides being a word which has seemingly made a lot of people very anxious recently, what is inflation?
Inflation measures the rate at which the cost of goods and services is rising over a period of time and, consequently, the rate at which money is losing its purchasing power. Whilst this may sound like an inherently bad prospect, inflation is a perfectly natural phenomenon and, in fact, a low and stable rate of inflation is actually desirable for a healthy economy.
This is why many developed nations target an inflation rate of around 2%. Maintaining inflation around this level encourages consumers to spend more money which consequently boosts economic growth.
However, problems arise when inflation begins to work its way significantly above this level and the costs of goods and services increase at a faster rate than wages can keep up with. Unfortunately, this is the situation we currently find ourselves in.
In the 12 months leading up to February 2022, the UK’s inflation rate was recorded as 6.2%, whilst that of the US was at a four-decade high of 7.9%.
How Does Inflation Affect Stocks?
So, how does inflation affect stocks? Unfortunately, there is no all-encompassing answer to this question as the relationship between inflation and stocks is far from straightforward.
Historically, the stock market as a whole has shown itself to be very resilient over the long-term, consistently recovering and rising regardless of what predicaments the economy has thrown its way.
Therefore, for long-term, experienced investors with a well-diversified portfolio of stocks, a period of high inflation will not necessarily cause grave concern, provided it is not prolonged, and they are able to be patient – both psychologically and financially.
In fact, a well-diversified portfolio of stocks is considered by many to provide fairly strong protection from inflation over the long-term.
However, it’s the short-term in which stock markets usually find themselves vulnerable and this is where the inflation effect on stocks is often negative.
Inflation and Stocks in the Short-Term
Why is inflation bad for stocks in the short-term? We can identify four key reasons to explain this relationship between inflation and stocks.
Firstly, inflation breeds uncertainty, which is one of the worst things that can happen to the financial markets. Amidst uncertainty, many investors act irrationally, panic and unwind their positions based on fear rather than fact. This can spark wide-spread sell-offs which leads to share prices falling in the short-term.
Secondly, central banks tend to respond to high inflation by tightening monetary policy, namely by raising interest rates. Generally speaking, interest rates and stocks are negatively correlated - meaning that if interest rates rise, stocks fall. One reason for this is that investors typically substitute higher risk stocks in favour of commodities and other “real assets” which are perceived to be better at holding their real value by increasing in price.
Thirdly, higher inflation reduces the purchasing power of money, meaning that if wages cannot keep up with inflation, people cannot buy as much as before. This leads to a fall in overall consumption, less revenue for businesses and, consequently, lower profits, which tends to pull share prices down.
Finally, inflation does not just affect consumers. A lot of the time, businesses are also forced to grapple with higher input costs, which can eat into their profits in the short-term. In the longer-term, many businesses are able to pass these costs onto their customers, hopefully restoring profitability. However, this is not always instantaneous. It can take a couple of quarters to realistically be able to implement price increases.
Stocks That Do Well During Inflation
It might be a bit of a stretch trying to identify stocks that do well during inflation. However, we can highlight a couple of important qualities which investors look for in stocks during such times and learn from this how to invest during inflation.
Pricing Power
One of the most important things investors will look for during periods of high inflation are shares in companies which have a substantial amount of pricing power.
In the previous section, we highlighted that businesses also often suffer from high inflation through higher input costs and, consequently, many raise prices to pass these cost increases onto their customers. What we didn’t mention though is that this is easier for some businesses than for others.
Some companies do not have a high level of pricing power. What this means is that if they increase their prices, consumers will stop buying their products. On the other hand, a company with high pricing power can increase prices without demand being substantially affected.
This idea of pricing power is largely linked to price elasticity of demand. The more elastic a product is, the greater demand will be affected by a change in price. On the other hand, price inelastic products are products whose demand is not greatly affected by a change in price, if at all.
Many things can affect a business’ pricing power, such as brand loyalty and competition. For example, if Company A produces a product which ten other companies also produce, and Company A has no brand loyalty amongst its consumers, then Company A has very limited pricing power. If they raise their prices, then consumers are likely to take their business to one of Company A’s ten competitors.
Companies that produce goods and services that are essential (food, medicine, energy) also have a lot more pricing power than those who don’t – and this also plays a large role in how they perform in inflationary times
Pricing power, therefore, is important for companies to remain successful during periods of high inflation, in order that they can pass their higher input costs onto consumers. Stocks that do well during inflation tend to have a high degree of pricing power.
Consistent Demand
Whilst identifying the best stocks during inflation, we have already looked at elasticity of demand from a business’ perspective, but what about from a consumers perspective?
When inflation is high, the purchasing power of a consumer’s money is being eroded, meaning they can buy less than before. This effectively means that, unless wages are rising in tandem with inflation, a consumer’s disposable income is shrinking at the same rate as inflation.
So, an important thing to look for when investing during inflation is for companies who produce goods whose demand is inelastic with respect to income. In other words, goods whose demand will not be negatively affected by a fall in the purchasing power of consumer income.
Identifying these types of goods is fairly intuitive. They are mostly essential items such as food, healthcare and other necessary consumer goods. Sin stocks as well are renowned for producing goods with inelastic demand such as alcohol and tobacco products.
Value Stocks and Inflation
Stocks are often divided into two categories: growth stocks and value stocks. Growth stocks are shares in companies which are expected to grow, or are growing, significantly above the market average. Sometimes, growth stocks are not profitable in the present, but are expected to deliver huge profits in the future.
Value stocks, on the other hand, are shares in companies which trade at a low price when compared with its fundamentals. Value stocks tend to be well-established companies which have robust fundamentals in the present and strong, reliable current cash flows.
During times of high inflation, investors favour stocks which have solid current cash flows over stocks which merely promise the possibility of strong cash flows in the future. In other words, investors prefer to invest in value stocks during inflationary periods and, as a result, growth stocks tend to suffer, whilst value stocks may stand to benefit.
Final Thoughts
Inflation can be a troubling prospect and many investors find it difficult to know exactly how to react. One of the important things to remember is not to panic.
The markets and their participants often act irrationally, and selling investments simply because other people are doing so is not a wise decision. Always do your own research and make any investment decision from a position of knowledge rather than based on what the crowd is doing.
When it comes to existing long-term investments, a lot of the time, the best thing to do is simply nothing, but this depends heavily on individual circumstance as well as that of the overall economy.
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