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Stocks and inflation have a complex link between them, and evaluating every stock according to its specific merits is important. In this piece, we will talk about inflation’s impact on stock markets in the long and short terms. Before we dive deep, let us start by discussing the basics of inflation.
- 1 What is Inflation?
- 2 What Causes Inflation?
- 3 How Does Inflation Affect Your Investments?
- 4 The Best Stocks for High Inflation
- 5 How to Protect Against Inflation?
- 6 Stocks and Low Inflation – Here is What You Need to Know
- 7 Does Inflation Cause Stock Prices to Increase?
- 8 What Happens to Public Company Earnings When Inflation Decreases?
- 9 Advantages and Disadvantages of Making Investments for Inflation
- 10 Important Points to Know About the Stock Market and Inflation
- 11 Stock Investment Tips during Inflationary Times
- 12 Final Thoughts
What is Inflation?
At its core, inflation is an increase in prices that causes purchasing power to decline over time. You can gauge how much purchasing power is affected by inflation by looking at the average increased rates of a basket of certain services and goods over a certain period. The increase in prices, often communicated as a percentage, indicates that a currency unit has a lower buying power than in the past.
What Causes Inflation?
The main reason behind inflation is an increase in the money supply. A nation’s monetary authority may increase the money supply by:
- Printing money and providing it to citizens
- Devaluing the currency legally
- Loaning more money and adding it to the reserve by buying government bonds banks offer on secondary markets. This is arguably the most common method to increase a nation’s money supply
In any of these scenarios, money loses its overall purchasing power. Three main mechanisms result in inflation because of this. They are:
This mechanism is related to the idea or expectations that people believe the current inflation rates will continue for the foreseeable future. With the increasing prices of services and goods, many people expect these prices to continue increasing at similar rates. Because of this, workers often demand more wages or costs to maintain their current standard of living.
The increased wages usually cause the prices of goods and services to increase, resulting in a wage and price spiral, which causes money to lose its value.
Demand-pull inflation happens whenever a rise in money supply and credit increases the demand for services and goods. The primary issue with this increased demand is that it rises more quickly than the economy’s production capacity. Eventually, the increased demand results in a price increase.
Whenever a high percentage of individuals have decent wealth, it results in positive consumer sentiment, which results in higher spending, causing prices to increase as well. This creates a massive gap between demand and supply, with high demands and not-so-flexible supplies.
Cost-push inflation happens when prices rise because of increases in raw material and wage costs. Higher production costs can lower the aggregate supply in a nation’s economy. Because the demand for certain goods and services does not change, the increase in prices from production pass onto the consumers, which results in cost-push or wage-push inflation.
How Does Inflation Affect Your Investments?
Equity prices and inflation do not have a straightforward relationship, and you cannot apply a catch-all rule. A well-thought-out stock trading or investment strategy would require you to analyze the particular characteristics of every stock being reviewed.
Stock Investments and Inflation in the Long Run
Shares can become a hedge that stock investors can use against inflation in the long run. A share portfolio or stock’s monetary value can increase during inflationary periods. When hedging against inflation, your stock’s monetary value will remain constant regardless of the price increase.
In situations where inflation is caused because of higher input costs, also referred to as cost-push inflation, once companies get enough time to adjust their prices, their revenues will eventually increase. Remember, the higher input costs pass on to buyers after a price revision period. According to economic logic, this is more suitable and realistic for properly diversified portfolios than individual stocks, as the latter carry certain idiosyncratic risks.
Stock Investments and Inflation in the Short Run
The short-term inflation dynamic may be less favorable for stock investors. What’s more, the relationship between inflation and equity prices is usually inversely correlated. This is because when inflation increases, stock prices go down. On the other hand, when inflation decreases, stock prices increase.
Inflation’s adverse effect on stock prices, especially in the short run, could happen because of several factors, which include:
- Plummeting short-term profits and revenue form a drag on the share prices
- An economic slowdown that creates an unfavorable environment for consumer spending and the stock market
- Introduction to monetary policies that result in high short-term interest rates that cause investors to exchange or substitute their stocks in place for low-priced bonds
- The possibility of negative or even lowered real returns decreases equity investment demands. Regarding inflationary environments, stockholders want to gain high returns from their stock portfolios. For instance, if someone makes a four percent gain from their portfolio annually, their real return will be three percent when there is one percent inflation. However, if the inflation increased to five percent, the stockholder would gain a negative return.
The Best Stocks for High Inflation
More often than not, value stocks outperform income and growth stocks, particularly in the short run when inflation is high. That said, how investors respond to increased inflation rates depends on certain factors, like whether they are taking a short or long-term view. Long-term investors should consider hedging against inflation and safeguarding their stored wealth’s value by letting their portfolio pass on increased costs to the customers.
Stock traders who want to play the short-term game must remember that high inflation often increases stock market volatility. Once that happens, investors can take advantage of several opportunities to short-sell or buy stocks.
How Do Value Stocks Perform When Inflation is high?
Most stock traders prefer value stocks during high inflationary periods. For those wondering, value stocks are a type of share with high intrinsic value, especially considering their present trading price. Established and mature organizations with strong cash flows, which could diminish eventually, particularly prefer value stocks. During high inflation periods, shares linked to large current cash flows have more value compared to growth stocks, even if they promise higher returns in the future.
Growth Stocks – How do they Perform during High Inflation?
Growth stock prices usually decrease when inflation is high. While these shares do not show substantial dividend payouts or current free cash flows, they can outperform the market later. Growth stocks are ideal long-term investments, and you can only expect decent returns after they get enough time to mature, which helps them produce above-average results consistently.
Income Stock Performance during High Inflation
While income stocks offer stable and regular dividends, they may be unable to keep up with short-term inflation. Unfortunately, income stock prices keep declining until dividends increase and meet inflation. Surprisingly, even international organizations experience declining share prices during high inflation periods.
It is worth keeping in mind that when a company increases its prices excessively, it runs a massive risk of losing to its competition. This is especially true if foreign competitors in the same market can maintain their prices over long periods.
How to Protect Against Inflation?
It must be abundantly clear by now that inflation can greatly devalue wealth, affecting buying power. Therefore, hedge against it to protect your investments. For those wondering, hedging against inflation means moving your wealth to assets that do not depreciate. In the best-case scenario, your asset may even appreciate at high rates. Consider trying these common options when trying to protect your investments from inflation:
Well-Diversified Stock Portfolio
The right stock portfolio could be a long-term hedge against inflation, especially if companies can adjust to high input costs by increasing their prices or opting for alternative inputs. If such a thing happens, free cash flows and revenues are likely to increase, re-establishing real income and dividends in the process. With dividends and inflation flow returning to regular levels, there could be a noticeable appreciation in stock prices.
REITs or Real Estate Investment Trusts
Real estate investment trusts are a decent hedging option against inflation, as rental rates and real estate prices are quite responsive when it comes to inflation. Real estate returns have been consistently resilient to consumer price level surges. Additionally, returns in real estate share several similarities with stock market returns, with less cyclicality and low volatility being the only difference.
Because of its excellent track record, seasoned stock investors traditionally use commodities as an inflation hedge. In most cases, gold is considered a haven during high inflation periods. That said, you must consider several factors before presuming your commodities will perform better than other assets.
ETFs or exchange-traded funds are an excellent option for those who want to gain exposure to the commodities market. Consider choosing funds that consist of different stocks to learn what will work best for you.
Sometimes, short-selling your stock could act as an inflationary hedge, especially if the market demand for said stocks decreases when inflation increases. Income and growth stocks could suffer lowered prices because of the decreased dividends value with future free cash flows.
Stocks and Low Inflation – Here is What You Need to Know
Low inflation is usually associated with increased spending and low-interest rates, so there is an increased demand for shares as organizations show more than decent revenues. This usually appreciates the share price. Low inflation is also ideal for any stock with low but reliable payouts. For those wondering, this is because of the modest inflation rates.
For instance, if there is a five percent dividend and three percent inflation, the actual interest rate will be about two percent. However, if there is only one percent inflation, the real interest will be four percent. The same applies to high risks stocks. There could be an increased demand for both, leading to higher prices.
Low Inflation Business Cycle and Interest
One of the most notable features of any inflation policy is the tightening of monetary policy. In such a policy, the short-term interest rate increases. The higher borrowing cost leads to lesser investments by households and businesses. Plus, disposable-income individuals would rather hold their interest-gaining assets than devalue money.
Inflation slows down with true economic output as long as the monetary authority acts correctly and the public deems it effective and trustworthy. Low inflation often causes interest rates to drop and encourages people to invest more. Growth and prosperity in almost any business cycle are closely linked to lower inflation and interest rates.
The implications are quite straightforward – whenever businesses and consumers spend, it should result in the general growth of the economy, whether through share price appreciation or dividends.
Lower Bonds and Inflation
Low inflation is fantastic for bonds too, and this is because it makes bond coupon payments less attractive. Because of this, investors expect a higher yield, which causes the debt burden to increase for those issuing the bonds. This, in turn, keeps investments financed by debts in check. Coupon payments are essentially cash flows offered by bond issuers to bondholders.
As people buy and sell bonds in open markets, price fluctuations can occur depending on factors like supply and demand. The term “yield to maturity” essentially means the interest rate equating the bonds market price with the current value of its corresponding future coupon payments.
The yield to maturity of a bond is higher if its price is low. It is also worth keeping in mind that a higher yield to maturity usually represents a high debt cost to the issuer. Since most organizations finance investments with the help of debts, high borrowing costs usually lower new bond supplies to the market.
Low inflation risk means that bond buyers are willing to pay more to secure their future cash flows when inflation is low. In most cases, the relationship between bonds and stocks is quite close, and there is fierce competition between the two for gaining investor funds.
Does Inflation Cause Stock Prices to Increase?
There is plenty of historical data about investment returns and stock prices during periods with high inflation, but most of it is contradictory. The amount of risk involved, who makes the investments, and several other factors influence whether stock prices increase or decrease during inflation. It’s also worth keeping in mind that inflation-time stock prices depend on which company the stock comes from.
Some organizations handle inflation pretty well, and their returns speak volumes. Companies with the power to raise prices according to inflation levels usually have stable bottom lines. Despite that, high earnings provide little value once inflation takes over. This is mainly because the dollar’s worth decreases, but the figures look good on the earnings reports. Plus, only some organizations can increase their prices, because of which their earnings will not look as good.
Sure, some companies may have steady or even higher stock prices, but that share’s underlying value could be lower than what people perceive. Consider this analogy for a better understanding – Just because a pencil’s price increased because of inflation does not always mean its stock will rise too. Dividend stocks and income-driven securities are volatile when inflation is high. This could result in slow growth rates and lower prices for high-dividend stocks.
What Happens to Public Company Earnings When Inflation Decreases?
If we look at inflation rates throughout history, it is clear that they eventually go down. However, it is hard to determine how long the high inflation rates last. Earnings and revenues in publicly traded organizations usually decrease when inflation drops. Once inflation comes under control, earning and revenue metrics no longer remain inflated.
Advantages and Disadvantages of Making Investments for Inflation
Any stock investor worth their salt knows that there are advantages and disadvantages to almost any investment hedge. That said, the primary advantage of investing during high inflation periods is to ensure your portfolio retains its value. Another important reason is to ensure your nest egg continues to grow. Taking such steps also encourages you to start diversifying your assets.
Spreading risks across different holdings is the most popular method to construct a portfolio stock investors use to fight inflation and increase their assets. Now, here is a look at some pros and cons of investing during inflation:
- It helps you maintain your income’s value and buying power
- Investing could help you diversify your holdings
- The right investment could preserve your portfolio’s worth
- Inexperienced investors could expose themselves to certain risks
- Investment during inflation could take your attention away from your long-term goals
- You run the risk of overweight or unbalanced portfolios (especially true if you are inexperienced)
Inflation often causes investors to panic, forcing them to make the wrong decision in haste. If you are in such a situation, don’t let inflation get the best of you. You may have particular timetables or goals for the investment plan you formulated and it’s important to stay within their bounds. Also, be aware of the risks around long-term growth stocks in times of inflation, especially if you want access to retirement income immediately. Remember, inflation shouldn’t move you away from your comfort zone of risk tolerance.
Remember, you don’t have any guarantees. Sometimes, traditional hedges against inflation do not work, and the markets can be hard to predict with surprises at every turn.
Important Points to Know About the Stock Market and Inflation
- Increased inflation results in high price levels and low “real income” levels until there are wage adjustments later.
- The relationship between stock prices and inflation is quite complex, so evaluating each stock on individual merits is vital.
- In the long term, organizations pass high input costs to the buyers. With sufficient time, such a strategy can help bring profits and revenues back to normal levels. This makes non-leveraged diversified portfolios a potential long-term inflation hedge.
- Inflation hedges can be valuable assets capable of outperforming the market when inflation is high, helping investors preserve their wealth. Remember, hedges are rarely perfect, and some of the best options you can choose are real estate, short-selling income, and growth stocks or getting a long-term diverse stock portfolio.
- Value stocks usually outperform income and growth stocks, particularly during high-inflation periods.
Stock Investment Tips during Inflationary Times
During inflation, people who know something about investments prefer value investing to growth because of the low share prices, low risks, and, most importantly, dividend income. In most cases, choosing securities resistant to inflation and combining them with value investing would be wise. Now, here are some tips for investing in stocks during high inflation periods:
- If you are inexperienced, consider enlisting the services of a professional financial advisor. The right advisor can help you create a portfolio reflecting your risk profile, timeline, and goals. With numerous advisors available, finding a reputable one shouldn’t be difficult.
- Developing your investment strategy means you will need to plan for taxes. However, calculating taxes can only be easy with professional help. If you want to see the possible impact of your capital gains, consider using an online capital gains calculator.
- Choosing a portfolio that reflects your risk tolerance can be challenging, so using a reliable asset allocation calculator could be a good idea. Doing so will help you choose the ideal percentage of stock for your portfolio.
Determining how long high inflation will last can be challenging as these periods could last for years or only a few weeks. So, adjusting risks and diversifying your portfolio according to the times will help you weather almost any economic event like inflation.
Investors always try to be on top of their portfolios by anticipating different factors that could influence them. Once they anticipate the possible elements, they make decisions according to their forecasts. While several factors could affect their portfolio, inflation is arguably the most notable. Some stocks could provide a hedge against it, mainly because an organization’s profits and revenues should increase with inflation once the adjustment period is over.
That said, the varying impact of inflation, especially on stocks, increases the risk premium and market volatility. Historically, high inflation correlates with lower equity returns, so if you are an investor, keep this and the other information we have discussed in mind to make a well-informed decision.
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