We witness every day how inflation affects our economy. And stocks aren’t an exception.
The association between inflation and stocks is complicated and requires careful examination to understand what to do. For this reason, in today’s article, we’ll talk about:
- Everything you need to know about inflation.
- How does higher inflation affect stocks?
- How does lower inflation impact stocks?
- What should you do to avoid inconvenience?
- The best way to hedge against inflation.
Let’s get started!
Inflation – Understand the Basics
Inflation represents an increase in product and service prices over time. It’s important to note that inflation isn’t referring to just one item or service – it relates to the general increase in prices across a sector or an industry and, ultimately, a country’s entire economy.
So, when inflation increases, the consumer can buy fewer goods, input prices go up, and income and profits go down. As a consequence, the economy slows down until stability returns. Most stock investors and others don’t enjoy higher interest rates and companies’ rising prices because it’s not adding to their profile.
The leading role of money is to act as a store of value. As a store of value, price levels are in charge of money’s purchasing power. Money plays other roles in our society – as a store of value and a medium of exchange. But, when prices increase, each unit of money becomes progressively less valuable.
Money isn’t the only way to store value; people can do that with other assets like stocks, bonds, and real estate. But, these assets must mostly be converted into money so people can exchange them for other goods and services. So, inflation erodes the value of everything – from income to money and investments.
It’s unusual to notice inflation’s adverse effects because it’s widespread. People who mainly spot its consequences are the ones with fixed incomes, especially in the loss of real income. Real income is evaluated as a selection of goods and services rather than a nominal currency amount.
On the bright side, stable inflation levels are associated with a low unemployment rate. One of the possible reasons for this is stimulation for business investment caused by higher prices. Or maybe, because the demand for consumer goods and services has risen.
The Federal Reserve and many economists say the stable and regular inflation interest rate is about 2% (or between 1% and 3%). They say it’s the required inflation rate for monetary policy to be effective.
And for borrowers, the inflation period might be beneficial. They can profit from holding fixed-interest rate loans. When inflation is rising, the actual borrowing cost is also lowered.
How does Higher Inflation Impact Stocks?
Sadly, the correlation between inflation and equity prices is not unequivocally. Stocks tend to be more volatile, but it depends on the specific characteristics of each stock, your situation, and your goals.
Some experts say the Fed’s action on inflation has the most significant impact on the stock market. In contrast, other financial advisors say that the value of stocks and prices in the stock market depends on the profitability of companies. It’s most likely that it’s both of these combined.
Speaking of the Fed, the Federal Reserve is currently trying to control high inflation. It hiked the benchmark interest rate by a half percentage point in May after increasing the rate by a quarter percentage point in April. They also outlined a plan to reduce its balance sheet ultimately.
How Does High Inflation Affect Stocks In the Long Run?
Generally speaking, periods of high inflation usually lead to higher interest rates, lower economic growth, and lower dividends. However, stocks perform well right after the inflation rate peaks. High inflation also can squeeze corporate profits with higher input costs.
For instance, Walmart recently reported that their profit in the first quarter of this year dropped 25% from the last period, and they essentially named higher costs as one reason for it.
In addition, when prices go up, consumers spend less on discretionary items such as cable TV, which can hurt them more than usual because, all other things being equal, a person will divert money away from necessities like groceries or natural gas.
There is another side of the coin. Some companies can benefit from a shift in consumer spending. The oil and natural gas sector is a good example. A colossal interruption in the distribution of natural gas and oil has led to an increase in price, which can help companies like Exxon Mobil. According to Nicholas Economides, Exxon Mobil’s stock price has risen over 50% this year.
Due to the slow economy, there is a fear of tipping the economy into recession. A recession is often bad news for prices in the stock market. In a recession, there’s a higher level of unemployment, and people spend less money. Thus, corporate profits drop.
Shares can help beat inflation in the long run for investors interested in stocks. More precisely, the monetary value of a stock or share portfolio can increase during the inflation period, so the ‘real’ wealth in store stays constant despite higher prices.
Earnings will increase, and regular profit rates may continue when inflation arises from higher input costs, also called cost-push inflation. For example, it can happen when businesses have enough time to adapt to the inflationary pressures and to accustom their prices.
How Does High Inflation Impact Stocks In the Short Run?
Most experts believe that the short-term dynamic is less beneficial than the long-term. The connection between equity prices and inflation is often an inverse correlation – when inflation rises, stock prices fall, and when inflation declines, stock prices increase.
Many factors influence adverse inflation on stock prices in the short term, including the following:
- An overall economic slowdown resulted in a destructive macroeconomic environment for the stock market performance and consumer spending.
- A monetary policy replies that involve higher short-term interest rates. It caused investors to replace stocks with lower-priced bonds.
- Falling income and short-term profits create a drag on share prices.
- Lowering the demand for equity investment due to decreased (or negative) real returns. Investors who intend to ensure a positive real return in the case of inflationary environments.
The Value Stocks
Experts interested in the negative connection between inflation and socks also believe that equity prices are controlled by the market’s estimate of a stock’s value. The reduced demand could be a by-product of market participants’ equity valuation strategies.
When you buy a stock, you’re banking on the company making money in the future. The ‘present value’ of a future cash flow is the most commonly used method to estimate what the future cash flow is worth in today’s money. The basic formula is this:
PV = C / (1 + i) n
- PV is the present value,
- C = future cash flow amount,
- i = interest rates,
- n = the number of times the interest rate is to be multiplied.
When calculating equity in terms of discounting future cash flows, current cash flows will be less reduced than cash flows of comparable amounts further in the future. For instance, let’s say you have a stock that pays a stable dividend at predictable and routine periods.
The stock’s value could be decreased to the sum of all the future dividend payments discounted to their present value. This analysis is the core of the dividend discount model (DDM).
When someone is using DDM, it diminishes the present value of each expected future dividend due to higher inflation. In turn, this decreases the current stock’s price.
The Growth Stocks
Research has shown that growth stocks slump in price during high inflation. Growth stocks mean shares that demonstrate the potential to outperform the market in the future while not offering current solid free cash flows or dividend payouts.
People with these long-term investments can expect profitable returns only after they have been mature and frequently produce results upon the average. When growth stocks are reduced to a present value, the compounded discount rate will negatively affect the current share price since the predicted cash flows are still some time ahead.
The Income Stocks
The price of income stocks will decline because income stocks pay a stable dividend that might not keep up with inflation in the short run. That’s why some international companies also decrease share prices when inflation increases. It’s a tricky position – if a company raises prices too much, there is a high risk of becoming uncompetitive if other companies find a way to keep constant prices in the same market.
How does Lower Inflation Impact Stocks?
In a period of low inflation, the cost of money is also low, and growth stocks, in theory, should perform better than value stocks.
Low inflation is in correlation with lower interest rates and increased consumer spending. Due to that, the demand for shares grows as companies show high business earnings, and as a consequence, we have share price appreciation.
Lower inflation is beneficial for stocks with lower but reliable dividend payouts. The reason is that the more modest the inflation rate is, the higher the real interest earned per payment.
Here is an illustration: if the dividend is 5% and inflation is 3%, then the real interest is 2%. However, if inflation is 1%, the real interest would be 4%.
The same refers to stocks with higher amounts of risk – one and the other might go through an increase in demand which would result in a higher price.
High dividend stocks, like utilities and REITs, usually suffer because investors have higher-yielding government bonds as a less risky asset and because dividends often do not keep up with inflation levels.
An important aspect of inflation policy is the short-term interest rate increase. Sometimes this feature is called ‘tightening of monetary policy.’ Consequently, the more significant expense of borrowing has less spending in investment by businesses and households. People with disposable income prefer to keep interest-earning assets instead of diminishing money.
Simultaneously the real economic output and inflation are slowing. Of course, for that to happen, a monetary authority (Central Bank, for instance) has done the right thing, and the public has seen it.
In contrast, interest rates can also decrease when inflation is low. In that case, interest rates are a reason to spend on investment.
So, the implication is: that when consumers and businesses are spending, the general economic growth should result in solid returns on equity. Returns can be through dividends or share price appreciation.
What Should You Do?
What should someone do when the stock market starts to fall? There’s no magic lever that automatically makes stock prices go down when inflation rises. However, investors managed to act when the U.S. The Bureau of Labor Statistics announced its consumer price index reports on the cost of goods and services.
Inflation isn’t the most positive occurrence in the economy, but there are some ways that you can invest. People can try hedging against inflation to move their wealth into assets that will resist depreciation. Or the best possible outcome is to have assets that will be appreciated at a higher rate than inflation.
Real Estate Investment Trusts or REITs
REITs are a possible way to beat inflation as real estate prices and rental rates are responsive to inflation. In past years, real estate returns have typically been resilient to surges in the consumer price index.
The real estate returns have been the most similar to stock market returns but are shown with lower volatility and less cyclicality. So, REITs are a merge of real estate assets that circulates dividends from income-producing property to trust shareholders.
Commodities are an old and widespread way to beat inflation. Primarily gold is used as the best protection for wealth during inflation. Many families have stories and vintage personal finance tips on how their ancestors survived, usually with gold or other precious metals.
But, even though it is an established and popular way, it isn’t perfect. Some experts advise first gaining exposure to the commodities markets through exchange-traded funds (ETFs) that include various stocks like VTSAX stocks.
The Ultimate Way To Hedge Against Inflation
Neither potentially high-yielding assets are perfect for everybody as inflation hedges, but in-depth research determines how beneficial the Infinite Banking Concept is. If you haven’t heard of this investment strategy, get ready to change your perception of investments during inflation (or in general)!
Infinite Banking Concept
Infinite Banking Concept or over-funded life insurance is a financial strategy that reduces peoples’ reliance on high-interest loans from traditional institutions. It’s called over-funded life insurance because this process rests on a whole life insurance policy which you use first to overfund it and, after that, to borrow money from it when needed.
Inflation impacts the drop in demand for risky assets. When rising interest rates rise, the annual percentage yield on savings accounts and money market funds jumps. So, you can avoid that with the Infinite Banking Concept. And additionally, the Infinite Banking Concept isn’t risky at all!
How does Infinite Banking Concept work? The concept is straightforward – you take a low-interest loan from a mutual insurance company, draw when needed and spend money however you like.
You are taking advantage of the policy’s low-interest rate, and instead of paying high interest to a lender, you repay yourself. That’s why the Infinite Banking Concept is sometimes referred to as the process of becoming your own banker.
It is the main idea – you imitate the standard banking process of taking loans and repaying. But, instead of traditional banks who get wealthy thanks to you (their profit on loans and interest rates), with the Infinite Banking Concept, you are getting rich thanks to you.
Why is it the best way to invest during inflation? Thanks to the life insurance policy underlying the Infinite Banking Concept, you ensure liquidity during inflation and have a safe space to keep your money.
Whole life policies earn cash value through interest and dividends. These earnings are liquid, and you can use them at any time. Even when you take out a loan, your policy’s cash value continues to grow. That’s why whole life is a perfect combo with Infinite Banking and in beating inflation – each dollar of cash value works twice as hard to combat inflation.
Other advantages of whole life over traditional investing are guaranteed returns and complete control in your hands. Besides guaranteed returns, if you get your policy from a mutual insurance company (which we recommend), you will earn additionally non-guaranteed returns based on the insurance company’s performance.
There are also additional features to the policy called policy riders, which can be used for multiple types of insurance products.
Some companies offer an Inflation Rider to support policyholders beat inflation. This rider is usually paired with long-term care insurance because rising healthcare expenses tend to increase rapidly compared to regular inflation rates.
We hope this article helped you understand how inflation impacts the stock market.
Even though, in some cases, stocks can be genuinely beneficial for investors during a time of inflation, there are too many risks. A safer and simpler option is the Infinite Banking Concept.
The Infinite Banking Concept is an investment strategy that can help you make more money, stop depending on banks and beat inflation. With the Infinite Banking Concept, you can build wealth even when there is an unstable global economy.