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How Does Inflation Affect Stocks?

How Does Inflation Affect Stocks?

It’s been a rough couple of years since the COVID-19 pandemic surfaced in 2020. The pandemic has changed the lifestyle of many Americans and impacted working regulations at companies across the states.

The pandemic also brought inflation with it, affecting market trends within a relatively short time frame. We are sure you’ve noticed the price movement at the grocery stores and the gas pumps. You may have even heard of the great resignation, a massive uptrend in employees quitting their jobs. How about the pandemic’s effect on the stock market?

The impact of Inflation can dramatically change your investment strategy. As inflation rises, it’s vital to understand its short-term effects on the value of your investment portfolio and stock prices.

What Is Inflation?

Inflation is defined as a sustained increase in the price of goods and services over a certain time period. Inflation causes the Federal Reserve (Fed) to devalue the dollar, increasing the average cost of living. Higher inflation also means higher prices on certain assets and input costs for investors.

Each year, there is an expectation among economists that the rate of inflation will increase 3%. The economy is on auto-pilot here and adjusts accordingly to what economists call an inflationary environment. However, when inflation increases faster and higher than anticipated, there is a negative reaction in the market, and the negative impact shows in the valuation of stocks.

Federal Reserve policymakers monitor price indexes to measure inflation. These indexes include the Consumer Price Index (CPI), Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index (PCE).

In January 2022, the government announced a 7% increase in the Consumer Price Index over a 12-month spread. This is the most significant increase documented since 1982, demonstrating the high volatility of the current market.

The Great Inflation

The Great Inflation lasted from 1965 to 1982. During this time:

  • The global monetary system established during World War II was deserted.
  • A total of four macroeconomic recessions occurred.
  • There was no restraint on how much inflation the Federal government could tolerate.
  • Companies watched prices and rates rise and didn’t look back, creating a wage-price spiral.

It was a period known as stagflation.

Economic growth came to a halt, but prices escalated and jobs became scarce. The stagflation is commonly associated with the climbing price of commodities like oil, as well as supply chain shortages.

Effects of Inflation

Purchasing power diminishes during times of inflation. Prices begin to rise enough that people have to rethink their purchasing strategies to continue living within their means.

With less purchasing power, companies suffer from less revenue and higher costs of goods sold and operational costs, decreasing their bottom line.

What Causes Inflation?

There are two types of factors that cause inflation:

  1. Excess Aggregate Demand (AD)
  2. Cost-Push Factors

Of these factors, the primary drivers of inflation are:

  • Demand-pull inflation
  • Cost-push inflation
  • Expectations of inflation

Some share common characteristics. Let’s look at these more closely:

Demand-Pull Inflation

Increased wages and values of houses are a couple of indicators that demand-pull inflation is in effect.

More money means more spending power and consumer confidence. To top it off, lower interest rates for loans during periods of high inflation help tip the scale.

Cost-Push Inflation

Along with increased wages, a hike in imported goods or raw materials hints at cost-push inflation.

Take crude oil as an example. As of March 11, 2022, the price per barrel of crude oil is $109.33, resulting in a 45% change yearly. This increase is in large part due to sanctions resulting from the conflict between Russia and Ukraine — in an effort to disrupt Russia’s economy and reduce its GDP, the United States has stopped importing oil from the nation.

Consider a waterfall effect now. Transportation costs more, period. Companies are bound to re-evaluate their financial statements and enact a price hike to compensate. The result? Inflated, even record-breaking, sales dictate the value of the stock on the market.

Expectation of Inflation

Panic sets in when people see the price tag has changed. For example, if you walk into a grocery store before inflation sets in and purchase a dozen eggs at $3.00. Then, as inflation takes its toll, they are suddenly a dollar more, and you start to wonder.

When people know inflation is on the rise, the walls go up. How long will inflation last in our economy? There’s no solid answer, but let’s hope it doesn’t lead to another Great Inflation.

How Does Inflation Affect Businesses?

It’s important to understand how a business is affected by inflation and how they react. The choices made by a company affect its bottom line, and its stock value is dependent on it.

Wages are one of the first to hit the spotlight. As inflation sets in and prices rise, employees begin to demand wage increases. If they are granted, profits may be affected. If they aren’t granted, profits could still be affected as resignations flood in and productivity stalls.

Rising prices for materials and shortages are another effect. Customers may need to turn to competitors if a business can not keep an item on the shelf due to supply chain issues. It takes more time to complete jobs, too, if their vendors are short-stocked.

Many businesses were just beginning to recover from the pandemic, only to find themselves spending more due to inflation. It costs more to do less. Also, each sector reacts differently to inflation.

What Does Inflation Do to Stock Values?

In the short term, the value of stocks could plummet temporarily. In the long term, they can perform as a hedge against inflation. Investors need to hold on to one key trait, patience.

What does history tell you about the performance of a stock? Each industry and sector tells a different story and requires your attention.

Generally, in the long run, stocks continue to perform well even during times of inflation. For example, not all companies suffer the consequences. Those that have fixed costs show stronger profits due to price increases.

There could be an adverse effect seen by the investor in the short term. This includes:

  • Noticeable drag on share prices
  • Substitution of stocks for bonds due to an increase in short-term bond interest rates
  • Decrease in returns, resulting in a decrease in demand

Value stocks are worth looking into when inflation hits the ceiling. Their value stays steady and provides long-term growth. They even pay out dividends, depending on the company.

When turning to invest in value stocks:

  • Do your research! Familiarize yourself with the company. Do they have short-term or long-term plans? How about their performance? Have they been succeeding against their competitors?
  • Look at the metrics. P/E ratios, high dividend yields, and high free cash flows are just a few. You’ll quickly learn whether the stock is in high demand or low, whether dividends are competitive with similar companies, and where their money is tied up.
  • Spread out your investments, don’t keep them all in one bucket.
  • Don’t expect to sell in the short term. Instead, hold on to your position and resist temptation.

What Investments Are the Best During Times of Inflation?

Think about adding more diversity to your portfolio, considering the following investments:

  • Inflation Index-Bonds
  • Cryptocurrency
  • Commodities
  • Real Estate

Inflation Index-Bonds

These are different from other fixed-rate bonds, which suffer when inflation hits. Inflation index bonds have variable interest rates.

A common type of inflation index bond is the Treasury Inflation-Protected Securities (TIPS). TIPS reacts with inflation, adjusting interest as the base value increases. The interest is paid to investors twice a year.

The U.S. Federal Government also backs TIPS. It’s a safe investment to think about adding to your portfolio.

Cryptocurrency

The latest and greatest in the economy is cryptocurrency. It is growing as both a popular form of investment and a new form of payment.

Bitcoin and other forms of cryptocurrency are used as a hedge against inflation, although the performance is not firmly set in stone. There is not enough historical data to comfortably state that crypto will act similar to commodities.

Commodities

What is a commodity? A commodity is a natural resource. Examples include gold, silver, oil, corn, and flour.

Commodities are purchased as tangible assets or bought through the market. One of the most popular is gold. Gold is fashioned into bars and coins and traded through dealers. It has proven to maintain its value and its beauty.

If you don’t have the storage space or prefer to hold onto commodities virtually instead, consider purchasing commodities futures, mutual funds, or exchange-traded funds.

Real Estate

Did you know that you can purchase real estate without the hassle of managing a property or dealing with tenants?

Real Estate Investment Trusts (REITs) allow investors to purchase shares from a real estate company that owns and operates real estate. Most are commercial properties such as apartment buildings, offices, hotels, and more.

The Bottom Line

No matter how hard investors try to predict the future, unforeseen events are difficult to plan for. Take high inflation as a prime example.

How your investment portfolio reacts is dependent on how it is diversified. Some stocks are riskier than others, some react positively when inflation hits, and others perform poorly.

Keep stock portfolios diversified and balanced. Drastic changes aren’t necessary but monitor them.

Gold acts as a hedge against inflation. Do you have some on hand or in your investment portfolio?

Visit Acre Gold to begin building your wealth with authentic gold bars that retain their value. Acre Gold offers affordable monthly subscription plans to make owning gold easy.

Sources:

The Great Inflation | Federal Reserve History

Causes of Inflation | Economics Help

How Inflation Affects Your Stock Portfolio | The Balance

Crude Oil Prices - 70 Year Historical Chart | MacroTrends

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