Inflation is one of the most popular and important economic indicators. It is monitored by everyone — businesses, financial regulators, and investors. Not only does it guide regulators in their policies, but also, it affects businesses, which in turn, influences investors. But what exactly is inflation, and how does it affect stocks? And more importantly, how does high inflation affect stocks?
Backtests reveal that inflation is bad for stocks in the short term. In the long run, though, companies should be able to pass on increased prices to consumers and resume their uptrend.
Inflation is a gradual reduction in the purchasing power of a currency over a given period due to the general increase in the prices of goods and services. In other words, you can buy less for $1 now than in the past.
In this post, we look at inflation and how it affects stocks. At the end of the article, we provide a backtest.
What is inflation?
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Inflation can be defined as a gradual decrease in consumers’ purchasing power over time due to a broad increase in the prices of goods and services. Some price changes are more important than others, which is why when calculating the average increase in prices, the prices of products consumers spend more on — such as electricity — are given greater weight than the prices of products people don’t frequently use.
Inflation, therefore, refers to the average price increase of a selected basket of goods and services over a given period. Because of the price increase, which is frequently expressed as a percentage, one unit of currency now buys fewer goods and services than it did previously.
What causes inflation?
The major causes of inflation include the following:
Printing more Notes
Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.– Milton Friedman
Inflation is a common side effect of a currency oversupply. This is because the availability of funds significantly impacts the prices of various goods and services. Prices will likely rise if many people with more money due to more printed notes want to buy the same goods and services.
We believe this is the leading cause of inflation – in the long term.
Demand-pull inflation occurs when there is excess demand for goods and services. This can happen when the supply of money in an economy increases, causing an overall increase in demand for goods and services. That is, the demand increases at a rate greater than the rate at which the economy can produce those goods and services.
In such a scenario, increased demand combined with less adaptable supply would almost certainly increase the prices of the various goods and services offered.
Increase in production cost
Businesses will respond to any increase in production costs by raising the prices of the goods they produce.
This will happen if businesses spend more money on production, paying wages, transporting goods, and maintaining overheads. As a result, cost-push inflation is common. The implication is that customers will have to pay a higher price for a product, reducing the value of their earnings and savings.
Increased inflation expectations
Built-in inflation is a subtype of common inflation that occurs when people anticipate future price increases. This type of inflation is linked to the concept of adaptive expectations, which refers to people’s expectation that the current rate of inflation will continue in the future.
When an economy begins to experience inflation, it becomes significantly more difficult to return to pre-inflationary conditions; as a result, it is natural for people to anticipate inflation.
However, if people behave in a way that makes them anticipate inflation, their predictions may come true. For example, if the price of goods and services continues to rise at the same rate as in the past, workers and others expect that prices will rise at the same rate in the future and demand higher wages to maintain the same standard of living.
The cost of goods and services typically rises in direct proportion to wage increases.
Will inflation cause the stock market to crash?
Stock prices tend to be more volatile when inflation is high. When inflation occurs, the overall market suffers because consumers spend less money. There is a chance that value stocks will outperform their peers because their prices have not kept up with theirs. Investors typically avoid growth stocks as they tend to have high P/E ratios and are already overvalued.
Because it takes several fiscal quarters for businesses to pass on higher input costs to customers, a sudden increase in inflation is widely regarded as the most painful type of inflation. It can reduce corporate profits by raising the costs of their inputs while causing consumers to spend more and have less savings. However, consumers and businesses will grow accustomed to the new pricing environment over time.
On the part of the investors, inflation leaves people with less money to invest as they spend more on essentials. For example, someone who plans to invest 20% of their income because they usually save 40% but now finds out that they spend 90% of the income on essential expenditures would not have much left to invest. In order words, inflation will make to have less money to invest, which can lead to a stock market decline.
One more thing, and the most essential factor, inflation can make the central bank raise interest rates to combat it. This will increase the cost of borrowing for businesses, worsening their cost of operation.
Excessive hikes in interest rates can lead to recession, as many businesses would find it tough to stay profitable, in which case a stock market crash must have already happened.
What happens to stocks when inflation is high? How does inflation affect stocks?
In the stock market, the price of a share is determined by its supply and demand, both of which are influenced by a wide range of factors such as social, political, economic, cultural, and many others. Since inflation affects, it can affect the demand for and supply of stocks. The interest rate is perhaps the most essential factor for stock market returns, and inflation determines the interest rate.
As inflation rises and bites harder, many investors may decide to sell their shares, causing the market price of the shares to fall. At the same time, investors who are optimistic about making profits in the future may purchase these stocks, causing the market to be volatile.
A change in the inflation rate significantly impacts value stocks, and this relationship is typically linear. As a result, value stocks tend to perform better whenever there is an increase in the inflation rate. On the other hand, growth stocks, which don’t often generate a lot of cash and tend to have high P/E ratios, have an inverse relationship with the inflation rate. When inflation rates rise, investors’ willingness to pay for those overvalued growth stocks falls.
When it comes to dividend-paying stocks, an increase in the rate of inflation can cause a drop in the market price of these stocks. This is because an increase in the inflation rate may cause dividends to fall short of keeping up with inflation, making the stock less appealing to investors.
What stocks do well during high inflation?
They are generally value stocks — stocks trading below their intrinsic value for one reason or another. Others are stocks of companies involved in gold mining and production, as gold is generally seen as a hedge against inflation. Here are some examples:
- Newmont Corp. (NYSE: NEM): Gold is one of the most price-insensitive commodities, and Newmont Corporation is the world’s largest precious metal producer. As a direct result of gold’s credibility as an effective inflation hedge, the price of Newmont’s shares increased by 31% in 2022, while other stocks are declining.
- American Tower Corp. (NYSE: AMT): This specialized Real Estate Investment Trust (REIT) runs the world’s largest wireless communications network and broadcast towers. Because more people are signing up for wireless services worldwide, the company’s revenue has steadily increased.
Who benefits from high inflation?
It is worth noting that inflation does not always have a negative impact; depending on your viewpoint, it can have negative and positive consequences. When inflation strikes, the purchasing power of your savings may suffer significantly; however, the value of your assets, especially real estate, may increase.
Inflation has the potential to benefit both lenders and borrowers. For example, because borrowers ultimately repay lenders with money worth less than what they borrowed in the first place, this practice is financially beneficial to the borrowers. As inflation rises, the costs of servicing these debts will become less than their original amounts. Inflation, on the other hand, causes interest rates to rise, which benefits lenders. It also increases prices, which benefits lenders.
Where do I put my money in high inflation?
According to financial experts, the best way to maximize your returns during times of rising inflation is to put your money into investments with a track record of producing higher returns than the inflation rate. Diversified index funds, stocks, bonds, and commodities are some examples of investments during inflation; others include gold and real estate. In the long run, stocks have produced positive real returns.
If you want to invest in gold-related businesses in addition to individual gold companies, you can put your money into a mutual fund or an exchange-traded fund (ETF) that owns gold. If you want to invest in real estate, you might want to check out REITs.
What should I invest in during inflation?
The Treasury Inflation-Protected Securities (TIPS) market is the most reliable hedge for investors seeking inflation protection. TIPS is an acronym that stands for Treasury Inflation-Protected Securities. TIPS are not as difficult to understand as their name suggests. The ETF with the ticker code TIP tracks TIPS.
The price of TIPS, which are government bonds, reflects the rise and fall of inflation. As a result, an increase in inflation leads to an increase in the interest rate paid. Furthermore, when there is deflation, interest rates fall.
TIPS are one of the safest investments because the United States government backs them. Furthermore, they are an excellent way to diversify your investments while supplementing your retirement income.
What happens to stocks when inflation is high? Backtest
Let’s do a backtest to show you how inflation might affect stocks. We assume that inflation determines the interest rates, and the interest rates determine the value of stocks. High inflation leads to higher rates and vice versa.
We backtest S&P 500 and make the following trading rules:
- When the 10-year yield crosses above its 5-weekly moving average, we buy S&P 500 (rates are increasing).
- When the 10-year yield crosses below its 5-weekly moving average, we sell S&P 500.
The backtest returns the following equity curve:
As you can see, the trading metrics and statistics are poor. After 60 years in the stock market, you would have less money than when you started! This is what we call an abysmal historical performance.
Thus, when inflation is high, stocks perform poorly – at least in the short term.
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