What does inflation do to the stock market? The answer is complicated but can be facilitated depending on whether there is a period of moderate to low inflation or a period of very high inflation, as is the case now in the United States
How does low inflation affect the stock market?
The stock market is an ongoing mechanism for assessing current economic conditions and discounting future conditions. The ideal stock market scenario is for there to be a period of low to moderate inflation, 1%-3%.
This is good because it means that the economy is not overheating, there is a healthy demand for goods and services, prices for goods and services tend to be fairly stable, and the declining value of each dollar is acceptable.
Inflation erodes the value of income, savings, investments and money in general. When inflation rises, as it is today in the United States, consumers lose a greater part of their purchasing power. They need more money to buy the same amount of goods than in the past.
For example, higher oil prices have significantly increased transportation costs. In the period of high inflation, companies have to pay more for raw materials, transport goods and run their factories. Of course, companies can increase the prices of their goods and shift some or all of the impact of inflation onto consumers. High prices are still not treated favorably by consumers.
High inflation, in short, causes a lot of uncertainty. As consumers have to make more accurate decisions about their spending habits, retail sales may slow, and in the US market, a slowdown in retail spending is very bad news. It can lead to lower economic growth.
Low economic growth will be negative news for investors, and the stock market is likely to be weak when inflation is too high. This explains the performance of the stock market in 2022.
Do stocks rise or fall during inflation?
When inflation is low, the cost of money is also low, and growth stocks should, in theory, perform better than value stocks.
Conversely, when inflation is high, value stocks should perform better as compared to growth stocks. But valuation concerns in a period of high inflation pushed the stock market lower.
The bad news is that high inflation takes time to return to the normal range. Inflation is over 9% in the US, and the normal rate of inflation is 2%-3%, so the Fed will have to increase the key funding rate to try to tame it. Using a higher risk-free rate in the discounted cash flow model for equity valuation, means that valuation of the stock goes down. Low valuations mean that there must be a gradual rebalancing between the observed stock price and its intrinsic value. The downside is the most sensible path to the stock market.
High inflation increases the cost of money and capital. Companies with a high level of debt fare worse in an environment where interest rates are high. This explains why high-growth stocks and debt firms suffer when inflation rises and interest rates rise.
High inflation makes the stock market more volatile
The stock market is already volatile in 2022 and is supposed to become more volatile with higher interest rates. High inflation can make nominal returns negative. For example, suppose you have a return of 5%-6% in your stock portfolio. When you consider that inflation is at 9.1%, the real yield, where you subtract the nominal yield from inflation, is negative. This makes stock picking in an era of high inflation more important than it is when there is low inflation.
A recession – two consecutive periods of negative economic growth – is likely when inflation is too high. This may turn investor sentiment into a no-risk mode, as it should, and thus cause a shift in investing style. I would argue that high dividend stocks are a safe option when inflation is high, because they compensate for the generous passive income for the loss of purchasing power.
In the end, high inflation is not only bad news for the stock market but an unsustainable economic condition that can hamper the growth and strength of the economy. To the extent that companies do not pass on inflation to consumers, this means lower profitability, and therefore higher potential for lower stock prices.
In short, high inflation is causing a lot of trouble for the economy and the stock market.
At the date of publication, Stavros Georgiadis, CFA (directly or indirectly) did not hold any positions in the securities mentioned in this article. The opinions expressed in this article are those of the author, and are subject to InvestorPlace.com Posting Guidelines.