The Impact of Inflation on Stock Returns

Introduction

Investors, the Federal Reserve, and companies are constantly monitoring and worrying about inflation levels. Inflation – the rise in prices of goods and services – erodes the purchasing power of each unit of currency. High inflation can be costly: input prices rise, consumers may lose purchasing power unless their incomes increase, and monetary measures to contain inflation can harm growth and employment.

How Does Inflation Affect Stocks?

Inflation generally negatively impacts stocks because consumer spending declines. Value stocks may perform well as their prices have not aligned with their peers. On the other hand, investors tend to avoid growth stocks.

Impact of Inflation on the Value of the Dollar

The chart below illustrates how inflation decreases purchasing power.

Effect of Inflation on Stock Market Returns

Examining historical data on returns during periods of high and low inflation can provide some clarity for investors. Many studies have examined the impact of inflation on stock returns. Unfortunately, studies often produce conflicting results. However, most researchers have found that generally higher inflation correlates with lower stock valuations.

Performance of Growth vs. Value Stocks in Inflation

Stocks are often divided into value and growth categories. Value stocks feature strong current cash flows that are likely to grow slowly or decline over time, while growth stocks represent fast-growing companies that may not be profitable.

What is Inflation?

Inflation is the rate of the overall general increase in the prices of goods and services over a period of time.

Why is Inflation Bad for Stocks?

Rising prices of goods and services increase uncertainty in markets. During periods of high inflation, corporate profits and growth margins may be affected, impacting investor confidence and consequently their willingness to take on risk by holding stocks.

Who is Most Affected During Inflationary Periods?

Those belonging to the lowest income brackets who spend most of their income on essentials typically feel the greatest impact from rising prices.

Conclusion

Investors attempt to forecast factors affecting portfolio performance and make decisions based on their expectations. Inflation is one of the factors that can impact a portfolio. In theory, stocks should provide some protection against inflation, as a company’s revenues and profits should grow with inflation after a period of adjustment. However, the varying impact of inflation on stocks increases stock market volatility and risk premiums. Historically, high inflation has been associated with lower stock returns. Value stocks tend to perform better than growth stocks during high inflation periods, while growth stocks tend to outperform during low inflation periods.

Source: https://www.investopedia.com/articles/investing/052913/inflations-impact-stock-returns.asp