Over the past year, the U.S. has experienced high inflation rates, that have made the products and services we buy more expensive. With November’s inflation rate ending at 7.1%, the effects of higher prices may have you wondering how inflation affects the stock market.
Investors and consumers alike are watching inflation closely. Higher prices and stock prices don’t have an obvious connection at first. We’ll take a closer look and inflation, stock market returns, and what you can do to weather inflation with your stock investments.
What is Inflation?
Inflation is when the price of goods and services goes up. Thus when inflation rises, your purchasing power goes down unless your income rises at the same level.
The government takes monetary policy measures to control inflation. If otherwise unchecked, rising inflation could harm employment and economic growth.
How Inflation works
To sustain economic growth, inflation should gradually increase across the economy. The Federal Reserve’s long-term target for annual inflation growth is 2%.
The inflation rate is measured by indicators such as the personal consumption expenditures price index (PCE). During inflationary periods where inflation is running high for a long time, it indicates an overheated economy.
This inflationary environment occurs when consumer demand is outpacing supply. The result is rising prices which is called demand-pull inflation.
Another scenario that leads to higher prices is when there are supply chain problems that increase the price of goods. This is called cost-push inflation.
In either of these cases, until spending decreases, prices will continue to rise. The economy can go into a recession when spending falls.
Inflation and Interest Rates
Rising inflation doesn’t mean that stock prices will be impacted negatively. Corporate profits may be higher, particularly with companies that use price hikes to pass along their higher costs.
However, higher interest rates have the opposite effect on stocks. When inflation rates rise, the Federal Reserve will generally raise interest rates.
This makes credit more expensive for consumers and companies. This discourages them from investing and spending.
Low Inflation and the Stock Market
The stock market is affected by several different factors, with inflation being one of those inputs. Sustained periods of low to moderate inflation that’s between 1-3% is the best scenario for the stock market.
The economy is not overheated in this state where supply and demand are at healthy markers and prices for goods and services are stable. The erosion of the value of a currency is at an acceptable level.
In most cases, growth stocks tend to perform better than value stocks in low inflation periods.
What happens with Stock Prices during Inflation?
When inflation is high, value stocks will generally perform better than growth stocks. Concerns about valuation, if there’s a period of high inflation, will tend to push the stock market down, however.
The cost of money and capital is greater during high inflation. Rising interest rates mean that the level of debt that some companies may have to take on puts them in a vulnerable position. Consequently, high-growth stocks of companies that have debt tend to suffer during times of high inflation and interest rates.
The stock market will generally be more volatile in periods of higher inflation and interest rates. Here is an example of what could happen when inflation increases in your portfolio:
Your stocks perform at about a 6% return rate. If inflation is 8%, then when you subtract nominal return from inflation, you’re at a -2%. That’s why choosing a diversified portfolio is more important when the inflation rate is higher.
When there are two consecutive periods of negative economic growth, it’s likely during times of high inflation. This type of scenario has a high probability of a recession.
During recessionary times, investors tend to shift their investing style. Investor sentiment shifts to finding less risky investments to add to their stock portfolio.
What you should know about Value vs. Growth Stocks
Certain types of stocks are more resistant to the inflation impact. During periods of high inflation, a solid investment strategy should include value stocks.
These types of stocks tend to before better than growth stocks when interest rates are high. Let’s look at how value stocks and growth stocks work differently below.
How Value Stocks work
Value stocks are generally less expensive stocks in which companies have a low price-to-earnings (P/E) ratio. This ratio looks at the company’s current share price to earnings per share.
Sometimes, a low P/E ratio indicates that the company’s stock is undervalued. However, this ratio isn’t always an indicator of poor performance.
When looking at value stocks, there are many other performance indicators you should review. Dividends, earnings, and sales for example.
These company fundamentals should match the lower price shared with its actual performance. That will tell you if the share price is low due to undervaluation.
Mature, but steadily growing companies that have stable earnings and revenues are oftentimes value stocks. These stocks tend to pay out dividends consistently and have higher returns over the long term.
How Growth Stocks work
Growth stocks have higher stock prices in most cases than value stocks. Companies that are considered growth stocks are expected to grow at a faster rate than the average.
Investors who are attracted to these types of stocks believe the company has a high potential for future growth. The potential for future cash flows when they sell their shares is the driving motivator.
Unlike value stocks, these stocks don’t pay dividends typically. So if you’re looking for regular or fixed incomes, growth stocks are probably not the right investment.
The presence of growth stocks in their industry tends to be high.
How to Invest in the Stock Market during
As an investor during high inflation periods, you’re feeling the effects of it from your wallet. You see price levels of goods and services rise, lowering your purchasing power.
But these times don’t have to throw off your financial goals completely. Here are some ways to navigate during these times:
Choose a Strategic Investment Strategy
Consider using the dollar-cost averaging strategy during these volatile times. This strategy involves investing a fixed amount of money in a security asset at certain intervals. This method is used to help reduce the overall cost of an investment.
You’re buying shares of a company when investing in a stock. The price of that stock may fluctuate, going up and down at certain times.
A dollar-cost averaging strategy involves buying a fixed amount of money into the stock on a regular time period such as weekly or monthly. This averages the price you end up paying for each share and reduces your overall cost.
Don’t get Emotional about Stock Market Performance
It’s easy to get caught up with stock prices rising and falling so fast. This fluctuation can cause a lot of anxiety.
It’s important not to make big mistakes like leaving the stock market in these times. When the market rebounds, you could lose out on a big opportunity. Over the long term, a buy-and-hold strategy will work best for you.
Diversify your Portofolio
Build and maintain a diversified portfolio during low inflation times. You don’t want to have too many value or growth stocks in your mix.
Consider your risk tolerance and use different asset classes to create a solid portfolio.
Another thing to consider is that your investment portfolio should be reviewed routinely. If you have a financial advisor, they should work with you to ensure that the portfolio’s still working the way it was intended.
Your portfolio may need to be rebalanced if the allocated stocks, bonds, and cash have shifted. The investment portfolio should match your investment objectives and risk tolerance.
Plan a Long-Term Strategy
During these inflationary times, we will unprepared for price increases and how inflation erodes our disposable income. But if you plan to stay invested with a long-term strategy, you’ll be able to keep up with inflation.