There are conflicting arguments as to whether inflation is good or bad for stock markets. The sensible answer is that it’s probably good for some stocks and bad for others.
Let’s start with the basics and understand what actually inflation is…
What is inflation and why is it important?
Inflation, the rise in the price of goods and services, reduces the purchasing power of each unit of currency. It can be costly for consumers, stocks, and the economy. Central Banks, businesses and investors continuously monitor and worry about the level of inflation. When inflation rises unexpectedly, it takes companies several quarters to be able to pass along higher input costs to consumers, and consumers feel the pinch when goods and services cost more. High inflation can stimulate job growth, but it can also squeeze corporate profits with higher input costs, causing corporations to worry about the future and stop hiring, reducing the standard of living of individuals, especially those on fixed incomes.
For investors, all this can be confusing, since inflation appears to impact the economy and stock prices, but not at the same rate. It is also confusing as these central banks whose job it is to control inflation, often want it to be 2%. There is a balance between wanting prices to rise, and not wanting them to rise too quickly.
The UK Prime Minister has a harsh view of inflation. In the leadership campaign to be head of the UK’s conservative party, he stated that inflation is the enemy that makes EVERYONE poorer.
Inflation is the enemy that makes everyone poorer.
That’s what I’ve been saying every day in this campaign, and for good reason.
We need to grip inflation and grip it quickly, not do things that make it worse.https://t.co/H2brxuzxUS https://t.co/ex2cac6pVO
— Rishi Sunak (@RishiSunak) August 22, 2022
The confusion around inflation and the stock markets makes it difficult for individual investors, there is no way forward other than sifting through the confusion to make wise decisions on how to invest in periods of inflationary uncertainty. Some types of stocks tend to perform better during periods of high inflation. Examining historical returns data during periods of high and low inflation can provide some clarity for investors. It is important to think about your specific portfolio, in conjunction with a qualified professional and think about which assets are you holding that might do particularly poorly or well during this volatile period.
To provide some insight into this, stocks are often subdivided into value and growth categories. This is one of the first things that undergraduate students in finance learn when they enter a Finance 1010 class. Famous investors such as Warrant Buffet also talk a lot about the differences between value and growth. Value stocks have strong current cash flows more likely to grow slowly or diminish over time, while growth stocks are likely to represent fast-growing companies that may not be profitable. Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest rates, growth stocks are negatively impacted far more than value stocks.
Has this level of inflation happened before?
Quite often we look at the past to assess how the economy will react, but as any economist will tell you, this is always the best idea.
Let’s take one example of how inflation has had a detrimental effect on US stock markets (like the S&P 500 ) during the huge inflationary period that occurred in the USA all the way back in the 1970s. During this volatile period, the FED (the US equivalent of the Bank of England), under the leadership of Chairman Arthur Burns, pursued expansionary monetary policies, which led to a significant increase in inflation. The Consumer Price Index (CPI), which is how inflation is usually measured still to this day, rose, significantly from 4.4% in 1970 to 11.2% in 1974, and reached a peak of 13.5% in 1980, rates that we thought were impossible to see again in modern times, but have become quite the norm in recent times due to the invasion of Ukraine from Russia.
This high level of inflation had a negative impact on the stock market. The S&P 500, a stock market index that represents the performance of the largest 500 companies listed on the New York Stock Exchange, fell by -4.9% per year on average between 1970 and 1980, after adjusting for inflation. This was one of the worst periods of stock market returns in the post-war period. These kinds of returns can really hurt an investor’s portfolio and take a significant period of time to recoup these losses.
The high inflation also led to a recession in the United States, which lasted from 1973 to 1975. The unemployment rate rose from 4.9% in 1973 to 9.0% in 1975. This further weighed on the economy and the stock market. As we know, recessions can damage economic growth and make it really difficult for certain firms to make money.
Additionally, during the period of inflation, interest rates also rose to combat inflation, which negatively impacted stocks, particularly growth stocks, as they have a higher sensitivity to interest rates. This caused many investors to shift their investments to bonds and other fixed-income assets, which tend to perform better in high-inflation environments. As we see in our article about the Big Tech firms, rising inflation is often not ideal, especially for firms with large amounts of debt.
This example of US history in the 1970s shows that high inflation can have a detrimental effect on stock market returns and the overall economy. It’s important for investors to be aware of the potential impact of inflation on their investments and to make adjustments accordingly.
In conclusion, inflation is a factor that may affect a portfolio, but investors try to anticipate the factors that impact portfolio performance and make decisions based on their expectations. In theory, stocks should provide some hedge against inflation, but it’s important to keep in mind how inflation may impact different types of stocks and to adjust your investments accordingly. It is also important to think about your personal finances as well as your portfolio, rising prices can impact the daily cost of living, and making savings here can also help you navigate the uncertainty and period of high inflation. To sum up, as in Rishi Sunaks tweet, inflation is evil for most, so it’s in most people’s interest to try and get it under control!
Want to learn how to maximize your returns in the market? Our previous post on the uncertainty of rising interest rates provides essential insights and tips to help you do just that. Click through to access it now.