How Does Inflation Affect Stocks?
After over a decade of moderate inflation, we’ve recently experienced a price spike. Inflation has been brought on by various circumstances, including supply chain disruptions, lockdowns resulting from the pandemic, and a significant monetary impetus.
But exactly how does inflation affect stocks? Read on to discover the essential information about inflation and which investing approaches perform the best over time.
What Is Inflation?
Inflation happens when costs for products and services rise steadily over time. When measuring inflation, however, food and energy are excluded because they sometimes change more drastically than the prices of other products and services.
The Federal Reserve increases the currency in circulation, which consists of liquid assets and cash in circulation. If there’s a significant increase in the currency in circulation, it can be an expedient for inflation pressures. The currency in circulation rose 3-5% per month from 2015 through March 2020. However, the Federal Reserve employed unconventional measures to counteract the economic turmoil caused by COVID-19; thus money supply increased by 20% every month starting in March 2020.
Along with increasing the currency in circulation, additional variables that contribute to inflation include a larger economy, more stringent regulations, supply chain interruptions, and fluctuations in the exchange rate. In addition, pent-up demand was eventually released following the COVID-19 pandemic lockdown. As a result, inflation rose to 7.9% in early 2022, a 40-year high.
Here are the two major types of inflation:
Demand-Pull Inflation
Our purchasing power grows when we have extra cash on hand. Demand for goods and services rises as a result. When this occurs, we observe an increase in the cost of goods and services, which, in turn, increases the profitability of businesses.
This is also referred to as demand-pull inflation. For example, as COVID-19 spread at first, the demand for disinfection products increased while the supply stayed the same. As a result, people were willing to pay more in the face of an insufficient supply to meet the demand, which caused the price of disinfection goods to rise.
Cost-Push Inflation
When there are delays in the delivery of goods or services owing to shortages, inflation also rises. The rise in prices for oil brought on by the current situation in Ukraine is one example of inflation brought on by a decrease in supply. A spike in the price of many other goods, including agricultural commodities, has also been caused by supply restrictions and disruption.
Even though there isn't a sudden or considerable increase in demand with this type of inflation, an increase in prices happens due to a relative scarcity in the supply. As a result, businesses or consumers are responsible for bearing the burden of increased manufacturing costs. This is also called cost-push inflation.
Referring to our earlier example, as Russia exports 11% of the world's crude oil, its production was halted or reduced, and supply didn’t keep up with demand when the ongoing conflict threatened a range of commodities. Due to this disruption in supply, crude oil prices rose. Despite some government attempts to regulate the price of crude oil, this price increase was further passed through to consumers.
Companies' profitability or earnings could drastically decline if they pay this additional cost, influencing their profitability. Poor corporate profits are likely to affect its stock price expectation since a company's stock price and long-term returns increase in tandem with its earnings growth. On the other hand, if higher prices are passed through to customers, it will drastically cut their disposable income and, as a result, the amount of money that is available for investment.
How Share Prices Are Affected by Inflation
Four factors, including business profitability, consumer spending, investors’ expectations, and the overall economy, impact stock prices.
Organizational Performance
Similar to how it raises the cost of groceries, inflation raises the price of the inputs used in production, such as raw materials, overhead, and labor. Due to rising input costs, companies have decreased profit margins, thus having a negative impact on stock values.
Consumer Spending
Consumers frequently don't have enough capital to buy consumer discretionary products since inflation lowers their purchasing power. Consequently, declining products and services demand results in decreased corporate profit and reduced net profits.
The Economy as a Whole
When inflation reaches this severe and persistent stage, the Federal Reserve intercedes by increasing interest rates, which raises the cost of borrowing. More expensive borrowing makes companies less eager to take on debt and deal with ever-expensive debt payments.
Investors’ Expectations
The impact of inflation on stocks is also influenced by its psychological component. Stock prices are influenced mainly by investor expectations. If the present value of future cash flows is lower in the minds of investors, they will operate in a way that actually lowers it, thus causing the stocks to drop.
Are Stocks Beneficial During Inflation?
Because inflation lowers purchasing power and devalues money, stock investments could act as a hedge against inflation in the long run. However, not all equities do equally well in this regard.
Look for companies that produce goods that people will continue to buy even if they become more expensive to locate inflation stocks, i.e., stocks that are more likely to increase during inflationary times.
Consumer staples, like food, beverages, and home goods, healthcare firms, like health insurers and producers of healthcare items, and utilities, like electricity, oil, and gas, can all be considered among these so-called "defensive stocks."
In general, value companies outperform growth stocks during an inflationary period. Therefore, you should search for equities with a low price-to-earnings ratio compared to their competitors. These equities would be undervalued, making them more likely to outperform their rivals in terms of returns.
How Does Inflation Affect Stocks: The Bottom Line
Due to decreased risk, higher share prices, and dividend income, value investing is usually a better business investment strategy than growth investing during inflation periods. Growth stocks may outperform value stocks in low-inflation and low-interest rate environments, whereas value companies often perform better in inflationary environments. Arguably the best strategy is to combine value investing with choosing inflation-resistant securities.
