How Does Inflation Affect Stock Markets?

The impact of inflation on a stock portfolio depends on several factors, including the degree of inflation, the overall health of the economy, the target holding period for the investment, and the specific equity sector.

Since the outbreak of COVID-19, fiscal stimulus, higher consumer spending, supply shortage of various raw materials, and rising gas and food prices due to the war in Ukraine have resulted in record levels of inflation across the globe. Inflation recently reached a four-decade high in the U.S.

Rising inflation can be costly for all aspects of the economy. Consumers, businesses, financial markets, and the broader economy are all affected. Inflation can force central banks to raise interest rates. It can erode the purchasing power of consumers. It reduces corporate profit margins due to higher costs. It can also cause wild price swings in stock markets, as we have witnessed throughout the year.

So is inflation also bad for the stock market? The answer is not as straightforward as it might seem. The impact of inflation on a stock portfolio depends on several factors, including the degree of inflation, the overall health of the economy, the target holding period for the investment and the specific equity sector.

In this article, we will explain the relationship between inflation and stock prices, and how investors can find investment opportunities in times of rising inflation.

What Is Inflation?

Inflation is defined as an increase in prices for goods and services in an economy. This price change typically occurs when there is a mismatch between the supply and demand of goods and services. When there is too much—or too little—of something in the market, its price is impacted.

The most common index used to measure inflation, the Consumer Price Index (CPI), tracks a “basket of goods” to serve as a proxy for the economy as a whole. This basket includes the goods and services that frequently pop up in monthly household spending, such as food, shelter, energy, autos, medical care, personal care, home furnishings and more.

The CPI currently shows high inflation in the U.S. Consumers there are facing higher fuel prices, higher electricity costs, and increased prices for staples like vegetables, cereals, grains and vegetable oils. Beyond utility and grocery bills, high inflation also impacts other important aspects of consumers’ lives, including higher rent for housing, property purchasing prices, and mortgage rates.

Relationship between inflation, interest rates, and stock markets

Inflation up to a certain level is generally considered good for Gross Domestic Product (GDP) growth, because it can boost consumer spending, investment returns, job growth and corporate earnings, among other things. Since the 2008 Global Financial Crisis, U.S. Federal Reserve policymakers have targeted 2% for core inflation to ensure “maximum employment and price stability” for households and businesses.

If inflation is in check, and the economy is in healthy shape, corporate revenues and profits are also expected to grow, resulting in greater market demand for the shares of companies with increased profits. A healthy economy with modest inflation often sets the stage for higher stock prices.

Historical data supports this positive correlation between the stock market and inflation. In fact, U.S. equity returns outperformed inflation 90% of the time when the inflation rate was rising but remained below the 3% benchmark.

It is only when inflation reaches high levels (typically considered to be 7% or more) that the relationship becomes more complex. At a macroeconomic level, high inflation can cause central banks around the world to tighten their monetary policy and raise interest rates in order to keep prices more stable. The expectation is that the resulting increase in borrowing costs will incentivize consumers to save and invest, instead of consuming more. This is supposed to eventually help to lower the demand (and therefore price) of goods and services, until a supply-demand equilibrium is achieved.

Over the long run, a rise in the prices of goods generally increases a company’s nominal revenue (their revenue before accounting for inflation), causing share price appreciation. At the same time, high inflation will also increase a company’s input costs (the amount of money spent on the raw material for manufacturing or creating a product or service). However, the expectation is that companies will gradually be able to pass these costs on to consumers through higher prices without significantly impacting their own profit margins. This is called pricing power, when a company has the ability to increase prices in the face of rising costs to maintain, or even grow, their profit margins. Some sectors, like food and energy, have more pricing power than others because what they sell is more of a necessity for consumers.

Stock Selection During High Inflation

Not all stocks are negatively impacted by high inflation. In general, stocks of companies that have pricing power, as well as those with strong balance sheets and the ability to continue paying good dividends to investors, will thrive better during unexpected periods of high inflation versus their peers.

Below are four types of stocks that have historically outperformed during periods of high inflation.

High-Dividend Stocks: High-dividend stocks may protect investors from inflation by providing a steady stream of income that can help offset the effects of rising prices. When a company pays dividends to its shareholders, it provides a regular payment in the form of a share of the company's profits. As prices increase due to inflation, the value of these dividends will also increase, providing investors with a source of income that can help maintain their purchasing power.

Additionally, stocks that pay high dividends may offer some protection against volatility in the stock market, as the steady income from dividends can provide a cushion against market fluctuations. From 1973-1981, a period of high inflation and low growth, the highest dividend-paying stocks produced annualized returns of 9.9%, performing better than both inflation (CPI at 9.2%) and the S&P 500’s dividend-adjusted annualized return of 5.2%.^[1]

Equity Real Estate Investment Trusts (REITs): Equity REITs can protect investors from inflation by providing a steady stream of income from the rental payments from the properties they own. As prices increase due to inflation, the value of these rental payments will also increase, providing investors with a source of income that can help maintain their purchasing power. Additionally, REITs may also offer some protection against volatility in the stock estate market, as steady income from rental payments can provide a cushion against market fluctuations. For example, REITs outperformed the S&P 500 Index in 2021 by 12.6^[2] percentage points.

Value stocks: Value stocks can protect investors from inflation by providing a steady stream of income from dividends and the potential for capital appreciation. Value stocks trade at a lower price relative to their intrinsic value, and they are typically associated with companies that have a strong financial position and a history of steady earnings growth. As prices increase due to inflation, the value of these companies’ dividends and potential capital gains will also increase, providing investors with a source of income that can help maintain their purchasing power.
Value stocks may also offer some protection against volatility in the stock market, as they tend to be less sensitive to market fluctuations than growth stocks. Value stocks are typically more likely to return capital faster to shareholders versus growth stocks. According to a recently published study, U.S. value stocks outperformed growth stocks by an average annual margin of 4.5% during years when inflation was higher than 4%.^[3]

Stocks in inflation-resistant sectors: Stocks in inflation-resistant sectors can protect investors from inflation by providing a steady income stream and potential capital gains that may help offset the effects of rising prices. Inflation-resistant sectors are typically less impacted by changes in the general level of prices in the economy, and include energy, health care, and consumer staples. These sectors provide essential products and services that remain in high demand regardless of the state of the economy. They often have stable revenue streams and high barriers to entry.

As prices increase due to inflation, the value of the income and potential capital gains from stocks in these sectors will also increase, providing investors with a source of income that can help maintain their purchasing power. For example, energy companies have historically outperformed inflation 71%^[4] of time in times of high and rising inflation.

Conclusion

Tackling inflation is an integral part of any financial planning strategy. While inflationary surges can dampen consumer spending power and corporate profitability, they can also create investment opportunities. For stock market investors, the key is to have an active portfolio management strategy to pick and choose the right companies and industries that can best weather the impact of inflation.

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