The Effect of Inflation on Stock Returns

Zarith Sofea · 22 Feb 5K Views

Investors, the Federal Reserve, and businesses consistently keep a close eye on and express concerns regarding the inflation rate. Inflation, characterized by an increase in the prices of goods and services, diminishes the buying power of each currency unit. Elevated inflation poses risks as it results in higher input costs, potential loss of purchasing power for consumers unless matched by increased incomes, and measures taken by monetary policy to curb inflation can adversely impact economic growth and employment.

Inflation and the Value of $1

A sense of how drastically inflation can lower purchasing power can be found in the chart below.



Because of the detrimental effects of growing inflation, the Fed remains vigilant and focused on identifying early warning indicators in order to foresee any unanticipated increase in inflation.

Since it takes businesses several quarters to pass on higher input costs to customers, the abrupt spike in inflation is usually regarded as the most painful.

Similarly, unexpected increases in prices create challenges for consumers as goods and services become more expensive. Over time, both businesses and consumers adapt to the new pricing dynamics, leading to a reduced tendency to hold cash due to its diminishing value in the face of inflation.

While high inflation can spur job creation, it can also exert pressure on corporate profits by elevating input costs. This, in turn, prompts corporations to express concerns about the future, potentially leading to a slowdown in hiring and negatively impacting the quality of life for individuals, especially those on fixed incomes.

Navigating the impact of inflation can be perplexing for investors, as it affects the economy and stock prices differently and at varying rates. Given the absence of a one-size-fits-all solution, individual investors must navigate through this complexity to make informed decisions on how to invest during inflationary periods. Certain types of stocks tend to demonstrate better performance in times of elevated inflation.

Inflation and Stock Market Returns

Examining historical data on returns in periods of both high and low inflation can offer valuable insights for investors. Although various studies have explored the impact of inflation on stock returns, the findings have often been inconclusive.

According to a report from the Board of Governors of the Federal Reserve System titled "Reexamining Stock Valuation and Inflation: The Implications of Analysts’ Earnings Forecasts" (Pages 27-29), researchers have generally observed a correlation between higher inflation and lower equity valuations.

This trend is not limited to developed markets; emerging countries also experience greater stock volatility during periods of higher inflation.

Research spanning back to the 1930s indicates that nearly every country faced its most challenging real returns during periods of high inflation. Real returns, calculated by subtracting inflation from nominal returns, reveal that the S&P 500 tends to show the highest real returns when inflation falls within the 2% to 3% range.

Inflation levels above or below this range often indicate broader macroeconomic challenges in the U.S., with varying impacts on stock markets.

Beyond the actual returns, it's crucial to consider the volatility that inflation introduces to returns and understand how to make informed investment decisions in such environments.

Growth vs. Value Stock Performance and Inflation

Stocks are commonly categorized as either value or growth. Value stocks typically exhibit robust current cash flows that are expected to grow slowly or potentially decline, whereas growth stocks often represent rapidly expanding companies, even if they are not currently profitable.

Consequently, when applying the discounted cash flow method to assess stock value, during periods of increasing interest rates, growth stocks are adversely affected to a greater extent compared to value stocks.

Given that interest rates typically rise to counteract high inflation, it follows that in times of elevated inflation, growth stocks are likely to experience more significant challenges.

What is Inflation?

Inflation refers to the general increase in the prices of goods and services over time.

Why is Inflation Detrimental for Stocks?

The escalation of prices in goods and services introduces uncertainty to the markets. In periods of increasing inflation, corporations may experience challenges in maintaining profit and growth margins, impacting investor confidence. This, in turn, influences their readiness to take on risk through stock investments.

Who Suffers the Most During Inflationary Periods?

Typically, individuals in the lowest income brackets, who allocate a significant portion of their earnings to essential goods, bear the brunt of rising prices the most.

Conclusion

Investors make decisions based on expectations by attempting to predict the variables that affect the performance of their portfolios. One of the things that could impact a portfolio is inflation. Theoretically, stocks should offer some protection against inflation since, following a period of adjustment, a company's revenues and profits should rise in line with inflation. On the other hand, the fluctuating effects of inflation on stocks tend to drive up the volatility and risk premium of the equity market. Lower equity returns have historically been associated with high inflation.


Growth stocks typically outperform value stocks during periods of high inflation, while value stocks typically outperform growth stocks during periods of low inflation.



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