How Inflation Affects Stocks

Every dollar not spent today faces a risk of depreciating in value. Whether you choose to wager it in high-risk investments or keep it safely tucked under your mattress doesn’t matter. 

Even with all other factors held constant, inflation will slowly – but surely – take a bite out of your money — the value of your dollar will depreciate over time. ⏲

But wait — what does this mean for your investments? What does inflation do to stock prices?

Typically, the stock market anticipates a certain level of inflation each year and adjusts the expected returns accordingly. But if inflation flares and shoots up suddenly, it strains the market and leaves it volatile. 

For instance, the surging inflation and the state of the economy at the moment have left many stock investors holding their breath. Inflation has now hit a record high — the highest sense in the last four decades. And the market is now feeling the heat. 

But even with all the noise, it is not clear whether these numbers are long-term or not. The truth is, in the long run, different stocks react differently to the effects of inflation. High inflation is considered negative for stocks in the short term as it increases borrowing costs, increases input prices, and reduces general living standards. 

This guide will tell you all you need to know about the relationship between inflation and your stock portfolio.

The Basics of Inflation 📚

Simply put, inflation is a measure of the continuous and sustained increase in the price of a ‘market basket’ of goods and services over time. As the prices increase, the purchasing power of a dollar decreases in tandem. 

For example, in 1950, a dollar could buy a lot more than it would today. According to the U.S. Department of Energy, a gallon of gasoline cost roughly about $0.29 in 1955. The same gallon costs close to $5.004 in today’s market.

And this is the trend for many other basic products and services. Consumer prices are surging, and inflation is the highest it has been in four decades — and it is still climbing. So if it feels like your income isn’t going as far as it used to, you aren’t imagining it.

The inflation rate is expressed as a percentage. Typically stable low inflation is considered necessary for a country’s monetary policy to be effective. Central banks strive to keep inflation rates between 1 and 3% to maintain the economy’s stability and benefit from their monetary policies. 

The Effect of Inflation on Stocks 🧐

Should the stock market investors be concerned about the surging inflation? The answer is a definite yes. 

It is evident that a sudden rise in inflation erodes the purchasing power of a dollar and, in turn, causes the value of investments (especially stocks) to fall in the short term. This is because stock prices and the general portfolio expected return are pegged to the past, present, and future (or expected) performance of the underlying companies. 

Inflation causes an increase in input prices — the cost of producing the product and services — and decreases the revenues of these companies. In addition, since inflation erodes the consumers’ purchasing power, people reduce their demand for various goods and services. 

As a result, companies’ profits and revenues reduce, knocking the economy off its balance. As the economy slows down, people have less money to invest in stocks. Additionally, more investors dispose of their shares to have more money to cover the difference in prices of essential goods and services.

The result is a volatile market situation. Typically, it takes a company a few quarters to self-correct — effectively pass the higher input costs on to their consumers. 

Also, high input costs coupled with fewer market demands can cause a company to reduce its production. This, in turn, makes the company limit its hiring and expansion. When this happens, the stocks are negatively affected as there is no growth. 

But despite all that, the exact effects of inflation on the stock market are unclear. Most studies carried out over the years show that the effect inflation has on stocks depends on the investors’ ability to hedge and the monetary policy existing in the economy.  

However, historical data shows a strong correlation between high inflation and a volatile stock market. Historically, the highest returns on the S&P 500 are experienced when inflation is between 2% to 3%. 

If the meter is higher or lower than this, it indicates a troubled economy, which can cause varying impacts on the stock market. 

Higher Inflation Impact 📈

In reality, no two shares of stock have the same reaction to inflation. Experts recommend always analyzing the specific characteristics of each stock under review as a unit.

How a specific stock performs during high inflationary periods depends on many factors. The key factors include the condition of the underlying company and time. Here is how time affects the stock market:

• ☑ Inflation and stocks in the long run. In the long-term, the value of a stock can appreciate, allowing its ’real’ value to remain stable despite the erosion of its purchasing power. For example, if there is cost-push inflation, the company can adjust to the pressures of inflation and raise its prices to accommodate the increase in input costs. As a result, sales will go up, and profits may return to normal, which in turn increases the value of the stocks. 
• ☑ Inflation and stocks in the short run. Although the relationship dynamics between inflation and stocks, in the long run, look promising, the same can not be said for the short term. In the short run, an increase in inflation pushes stock prices down. Inversely, when inflation drops, stock prices tend to rise, and the stock market thrives.

Lower Inflation Impact 📉

Lower inflation is all good news for the stock market. On the one hand, people have more to spend on the stock market. On the other hand, the cost of production is lower, and therefore companies show strong revenues. As a result, the demand for shares increases, and share prices appreciate.

Low inflation is especially good news for stocks with lower, but reliable, dividend pay-outs as reasonable inflation translates to higher the real interest received per payment. For example, if a stock pays a dividend of 7% and inflation is 4.5%, the real interest rate is 2.5%. But if the dividend is 7% and the inflation is at 1.5%, the real interest is 5.5%. 

Low inflation is desirable both in the short run and in the long run. For example, in the last 10 years, when the inflation was very stable, the stock market returns averaged 14.8% return. This is considered stable as it surpasses the long-term historical average of 10.7 percent since the introduction of the benchmark index 65 years ago.

Inflation Effect on Cash and Bond 💰

If $10,000 was maintained in a savings account throughout 2021 up to today, it now has a purchasing power of $9,200 (a decline of 8%) compared to a year ago. If inflation continues to rise and the economy continues on the same momentum, the value of the $10,000 will decrease even further. 

Similarly, bonds with fixed long-term cash flows tend to depreciate in value in the face of inflation. Their ‘stated’ interest rates don’t take inflation into consideration. Therefore, as inflation rises, the real wealth held by a bond depreciates — the purchasing power of the cashflows falls over time. 

Additionally, a bond’s ‘real’ value tends to be negatively affected by the Fed’s interest rate adjustments. For example, if an investor buys a 10-year $1,000 bond paying a 3% coupon interest, and the Fed increases the market interest rates by 4%, the bond value would likely fall to $925.

Like cash, the longer the inflation persists, the more pronounced the loss of value. In addition, the longer the bond maturity, the more pronounced the inflation effect.

But it is important to keep in mind that not all kinds of bonds get unhealthy with inflation. Some bonds can help hedge against the effect of rising inflation. These bonds include global bonds, high yield bonds, and the famous Series I savings bonds. 

Growth vs. Value Stocks During Inflation ⚔

In the stock market, there are two different investment strategies; value investing and growth investing. Value stocks are stocks that have a strong short-term cash flow but tend to grow slowly or diminish in value over time. 

On the other hand, growth stocks are stocks that have no real profit in the short term but have a high potential to grow exponentially in the future. An excellent example of such stocks are stocks of a fast-growing technology company. 

Historical data indicates that, on average, value stocks perform better than growth stocks during a period of high inflation and increasing interest rates. This is because value stocks already have a steady cash flow that is likely to decrease in the future. 

Inversely, growth stocks tend to behave like bonds during high inflationary periods. High inflation erodes the purchasing power of a bond’s fixed-rate income payments over time.

Stock Market Return and Inflation 💵

Typically, the stock market runs on the rule of demand and supply. Therefore, anything that affects the investor — political, social, economic, and cultural factors – affects the stock market. 

As earlier mentioned, the exact effects of inflation on the stock market returns are not apparent. Experts all over the world have studied the trends and carried out different types of research, but the results are always conflicting. But most economists tend to agree that high inflation has an overall negative effect on the stock market. 

At face value, high inflation causes stock market volatility. Historical data on developed and emerging markets shows that high inflation generally correlates to low returns on investments and low equity valuations. However, the impacts might be felt more in developing countries than developed countries because of various other factors.

An analysis of historical data on inflation and the stock market indicates that many countries around the world have suffered their worst actual returns during high inflationary periods. 

For example, looking at the S&P 500 ‘real’ returns (returns adjusted for inflation) by decade, it’s apparent that the highest ‘real’ returns are experienced in the times when inflation was between 2% to 3%.

Inflation higher or lower than this indicates other significant macroeconomic issues that have varying effects on the stock market. 

Hedging Against Inflation 📖

Inflation can be infuriating. 

After all, no one commits their money to investment because they are bored or have nothing better to do with their hard-earned money. Everyone wants to get some return from their money.

Picture this: You find a pill that is rumored to make a human live forever. But for it to have maximum effects, it needs to be kept in a special incubator for a few years. So you find an incubator and incubate your pill. A few years later, you go to check on your pill, but instead of getting more effective, the pill’s essence is diminishing. The value of the pill has diminished, and your hope of living forever is now threatened. This can be infuriating, right? 

Although a bit far-fetched, this story is similar to what happens to your investment when inflation flares. 

So as an investor, how do you protect your portfolio from inflation? To minimize the effect of inflation on investment, investors use inflation hedges. Hedging refers to a strategy of using an asset or combination of assets to try and reduce or eliminate certain types of risks on a portfolio — in this case, inflation.

In the current economy, worrying about the effects of inflation on your investments is no longer enough. 

You must actively protect your portfolio against the unforgiving claws of inflation by investing in multiple asset classes that can outperform the market volatility during inflationary climates.

To win against inflation, an investor needs to meticulously plan and tailor his portfolio in a way that can shield him against the negative impacts of inflation.

Alternative Assets to Invest in During Inflation 🗃

Here are some alternative investments that can help hedge against inflation:

Bonds 📃

Bonds are government-issued debt securities that are used to fund the government’s spending and obligations. There are two types of bonds; fixed and floating. 

While fixed bonds offer fixed returns for the asset’s lifespan (which can be vulnerable to inflation), floating bonds’ interests are adjusted frequently in tandem with changes in inflation. In other words, floating bonds grow as interest rates grow due to the effects of inflation. This makes floating bonds a reliable hedge against inflation.

A good example of a floating bond is the Series I savings bonds (commonly known as I bonds). I bonds are a popular inflation hedge due to their ability to lock the purchasing power of a dollar through the regular interest adjustments based on prevailing inflation – interest rates change every six months to adjust for inflation.

TIPS 📜

Tips are a type of bond specifically designed to protect investments against inflation. In other words, TIPS have an inbuilt inflation buffer that allows an investor to protect the value of his investment from inflation. 

To ensure that the investor is not affected by the inflationary changes, the U.S. Treasury adjusts the per value annually for inflation. This means that the treasury adjusts the principal amount to reflect the changes in inflation.  

This ensures that the return on investment includes the principal value adjustment. However, although the investor might successfully hedge against inflation, there is no guarantee for growth. For example, the iShares TIPS Bond ETF, which tracks a TIPS index, posted average annual returns of a little over 3% over the last decade.

Gold 🥇

Gold and other precious metals hold a special place when it comes to hedging against inflation. Precious metals perform well when hedging against inflation because, in the real sense, they are physical assets that are able to hold value for the most part. 

Historically, the value of gold has always been on the rise. For example, the gold value was set at $35 oz in 1944, and as of August 2020, it was valued at $2060 oz. Therefore, the value of a precious metal doesn’t decrease as the value of a dollar erodes. In the real sense, we can say that the value of gold doesn’t change, but remains constant as the value of a dollar declines. 

This is why some of the most sophisticated investors must include gold in their investment portfolios. Gold is so great that it has the power to replace a normal currency when a country’s value is falling. 

Real Estate 🏢

Typically, real estate prices and inflation tend to move in the same direction – property values and rental income increase with the increase in inflation. Typically, as inflation pushes up wages, budgets for buying and renting also increase. 

For example, with how inflation is flaring lately, rent in most desirable cities has already increased by over 30% in a span of just a few months. This means that investors who hold real estate investments in these cities don’t have to worry about inflation eroding the value of their investments.

This is why many smart investors rely heavily on real estate to protect their portfolios against inflation. For retail investors who cannot afford the big buy-ins required in the real estate market, a reliable REIT (real estate investment trust) provides a shortcut and a great platform to get your foot into the game.

Commodities 🛢

Commodities refer to a wide range of raw materials and agricultural goods that are publicly traded. They include petroleum, fine wine, metals, and foreign currency. Generally, as the demand for different products goes up, so does the need for the commodities that are used to make them. 

This causes commodity prices to go up. Due to the fact that commodity prices normally increase even when inflation is increasing, they provide great protection against its impacts. For example, by the end of 2021, commodity ETPs (excluding precious metals) grew by 36.5%, while inflation reached 7%.

It’s therefore advisable for every investor to include at least one commodity in their portfolio. This provides the investor with multiple degrees of downside protection and upside potential.  

Inflation Trading Strategies 👨‍🏫

Inflation is brutal. It can be unforgiving and impacts everything from food prices to mortgage rates, as well as the profits on investments. Therefore, in the war against inflation, only the strategically prepared investors are likely to win. The wishy-washy ones are often left with regrets.

But what exactly is inflation trading?

Simply put, inflation trading refers to an investing method where an investor uses inflation (existing or expected) to profit from the increasing price levels. 

It’s not uncommon to see many investors turn to inflation trading as soon as there is an expectation of price increases, or when they anticipate a significant adjustment to interest rates by the Federal Reserve (Fed) over the coming months. 

An investor is considered to be involved in inflation trades when they shift their portfolio assets or actively trades (speculatively) assets that are highly susceptible to price inflation, like the dollar. Typically, these investors will rotate their portfolios into assets that they believe are more favorable in an inflationary environment with the hope they can benefit from the price surges.

Knowing what works and what doesn’t work is not easy. 

Most novice and intermediate investors can rely on their stock brokers to provide key information on the market performance – many top stock brokerages offer this service.

But advanced investors, who tend to be more hands-on, prefer to use trusted stock analysis tools to discover and exploit all the opportunities available that could help them benefit from the inflation.

Arbitrage Investing 📙

During inflation, every investor wants to protect their portfolio from value erosion. Arbitrage trading refers to a strategy where an investor simultaneously buys a security from one market and sells the asset in a different market at a profit. 

Historically, many sophisticated and quick-witted investors have always taken advantage of arbitrage opportunities to grow their investments. These investors actively seek and exploit any arbitrage opportunities available in the market to profit from the temporary difference in cost per share.

For example, Tom, a seasoned investor, can strategically seek and buy stocks in a foreign exchange market where equity’s share prices are yet to adjust for the exchange rate. Once the stocks are adjusted for inflation, Tom will sell his holding and profit from the temporary difference in the stock price. 

Although this might sound complicated at first glance, it is a simple and low-risk process that allows investors to harvest gains by positioning themselves at an advantage.

Big institutional investors and professional traders can also take advantage of statistical arbitrage and algorithms to identify price mismatches in the market and exploit them. 

Historical Examples of Inflation in the U.S. 📝

In the U.S., prolonged inflation is rare. The most notable inflationary period in history was in 1778 with a high of 29.78%. This has been the highest it has ever been since the founding of the United States in 1776. The second-highest ever recorded was 20.49% in 1917, soon after the introduction of the Consumer Price Index(CPI).

Both of these incidences of high inflation coincided with the peak of major political turmoils – the Revolutionary War and World War I. 

The other notary inflationary period in the history of the country is The Great Inflation which lasted from 1965 to 1982. This period was noted down in history as the defining macroeconomic period of the second half of the twentieth century.

During this period, the stock market was shaken. Unemployment hit an all-time high, and prices of goods and services were over the roof. According to one prominent economist, professor Jeremy Siegel  “the greatest failure of American macroeconomic policy in the postwar period.”

During the time, economists blamed inflation on factors such as surging oil prices, currency speculators, and avaricious union leaders. But unclear monetary policies used to finance massive budget deficits contributed to the inflation. 

In the last few months, inflation rose from less than 2% to 8.6% in May 2022. This rate is well above the central bank inflation targets in almost all advanced economies. 

The steadily rising inflation we are experiencing today somehow echoes the Great Inflation of the 1970s. 

First, the main trigger of this inflation was the supply disruptions caused by the pandemic, which was then fueled by the supply shock dealt with energy prices by the war in Ukraine. 

It feels like Déjà vu all over again. For example, the current pressure on oil prices feels like the oil shocks experienced in 1973 and 1979–80. 

Inflation’s Effect on the Dollar’s Purchasing Power 💸

It’s no surprise that a few years from now, $100 will get you much less than what it can get you today. Inflation erodes the dollar’s purchasing power.

 Due to inflation and the steady increase of the CPI, the value of the dollar has continued to decrease since 1913. The purchasing power of a dollar has a negative correlation with CPI. Over time, and as the CPI increases, the purchasing power of a dollar decreases. 

Typically, economists track the purchasing power of a dollar in order to understand the effects of inflation on a consumer’s ability to afford certain goods and services. 

Hence, inflation and purchasing power are correlated, or rather, they are two sides of the same coin. As inflation increases, purchasing power reduces, and vice versa. 

However, in the real world, many factors contribute to an individual’s purchasing power. For example, an increase in the prices of certain goods and services can be due to a quality improvement. For example, although the cost of medical care has increased over time, it might be due to more advancements in both medical technology and quality of care. 

Typically, sustained inflation arises when the world’s monetary base outpaces economic expansion; hence, many argue that the world’s central banks must work together to sustain economic stability. This is not necessarily a negative aspect. 

Generally, slight controlled inflation is good for the economy, and it helps boost stock prices. It helps sustain property prices and prices of other tangible assets.

Inflation Impact on Your Portfolio 🧾

Inflation has different effects on different assets in a portfolio. 

Savings 🏦

If inflation were a dog, savings would be a nice tempting bone. Inflation shrinks the value of savings — including money held in yield accounts with average interest income. 

For example, inflation has increased by an average of 2.47% per year between 2010 and today. As a result, a $1,000 left in a savings account in 2010 is equivalent in purchasing power to about $1,340.46 today. This means that the purchasing power of the $1000 has decreased by 34.05% in the last 12 years. 

Therefore, if you choose to keep your money in savings accounts, especially retirement savings, it’s advisable to factor in inflation to ensure that you have enough resources to last through the retirement years. 

Fixed Income Investments 📄

Fixed investments such as bonds, treasuries, and CDs give investors a steady fixed income throughout the life of the investment. At face value, this might look like an excellent investment that guarantees an income for the investor. 

However, since the interest rate remains fixed through the life of the investment, the purchasing power of the interest income declines as inflation rises. This reduces the present value of its future fixed cash flows.  

Just like the example of $1000 dollars above, $1000 worth of fixed investments will not have the same value 12 years from today. 

Stock Investments 📊

The relationship between inflation and stock performance is not straightforward. A deep analysis of historical returns data during high and low inflation periods can provide some insight. While some experts believe that stocks have a positive reaction to inflation, it is yet to be proven true.

Therefore, as an investor, it is essential to remember that every stock reacts differently during inflationary periods. Some gain while others lose value when inflation flares. 

In addition to analyzing the historical returns data, a prudent investor should analyze each stock independently to understand its relationship with inflation. How a stock reacts to inflation depends on multiple factors, including the internal dynamics of the underlying companies and how well it’s prepared to deal with the effects of inflation. 

Real Assets 🎯

Historically, real assets such as commodities and real estate tend to perform well during inflationary periods. Their value increases with the increase in inflation which makes them a good hedge against inflation. 

This is why you will find a real asset in any sophisticated investor’s portfolio. Inflation is measured using the prices of goods and services, which includes commodities and other goods related to commodities. 

For example, when energy-related product prices increase, investors with energy-related investments in their portfolios are likely to benefit from the increase. This also applies to real estate. As prices of goods and services surge, property prices go up — which can flow through to profits and investor distributions.

There is no one-catch-all rule regarding inflation and an investment portfolio. However, at the very least, it is clear that most assets with fixed cash flows tend to perform poorly during inflationary periods. Increased prices reduce the number of goods and services that cash flow from such investments can buy. On the other hand, assets and commodities with variable returns tend to hold fort in such periods. 

With the prevailing economic conditions, inflation is likely to average above 4.5% for the next few years. This number is well above the stable average of 1.7% experienced in the last 10 years. Therefore, it’s understandable that investors who rely on investments for capital preservation, liquidity, and cash flow are at the edge of their seats, eyes on the meter.

Conclusion 🏁

The relationship between stocks and inflation is complex. While some factors do indicate that high inflation has an overall negative effect on the stock market, there is no conclusive study available to support this theory.

However, as a rule of thumb, it is crucial to look at each stock as a unit to understand its reaction to changes in inflation. Most stocks tend to behave similarly both in the short run and long run,

There is an inverse correlation between inflation and share prices in the short run. When inflation surges, stock prices fall, and vice versa. In the long run, most underlying companies have already successfully transferred the input price differences to the consumers, and revenue and profits have stabilized, allowing the value of the stock to go back to its normal trajectory. 

However, all said and done, investing is a game of cat and mouse — its very nature is rife with uncertainty and chance. Some experts believe that when inflation is high, value stocks tend to outperform growth stocks in the short term.

This is why experts advise investors to test and treat each stock as a single unit when analyzing them for effects of inflation.

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