Inflation is a hiding enemy to the economy. Central banks all around the world watch inflation levels closely and try to keep them in control. In this article, you will find answers to – What is inflation? How does inflation impact the stock market? What happens to stocks during rising inflation? etc. Let’s get started.
What is Inflation?
Inflation means the rise in price levels of goods and services. During inflation, consumer purchasing power erodes. That means, all the products and services become costlier. Earlier, if someone got 10 chocolates for a dollar, with the rise in inflation this number decreases. During high inflation periods, the currency flow increase in the economy and to control this central banks rise interest rates.
Since inflation eats away the money value, investors don’t want to hold the cash. Instead, they invest in various capital appreciation assets to increase their monetary value. Often they choose real estate, stocks, commodities like gold and silver over saving or fixed deposits. Read more about inflation here.
What happens to stocks during rising inflation?
Like every other good in the economy, the price of shares also increases. Investors feel that share prices are increasing because of the company’s growth but that is not the entire scenario. During rising inflation, the cost of goods increases. That means, companies need to spend more money to buy the same quantity of goods which they used to get earlier for less money. Because of rising prices, the company’s expenses increase. To maintain profitability, companies pass on these extra expenses to the consumer by increasing the prices of their products.
If you observe keenly, inflation plays a delusion effect on the investors. To avoid this delusion, the investors should carry out a detailed analysis of the financial statements. Don’t decide anything just by looking at the increasing share price.
Always consider real growth rather than nominal growth. Real growth considers inflation, but nominal growth ignores it. For easy understanding, follow the below scenario.
The share price of a company increased by 10% but during that period the inflation is at 8%. In this case, 8% of the share value is eaten by inflation. So, the share value growth = 10% – inflation = 10% – 8% = 2%. That’s why I always consider real values instead of nominal values.
How inflation affects stocks in the short run?
Due to increased inflation, companies revenues fall and thus the share values. High interest rates, lesser revenue, decreased profits all affect the stocks in the short run. Stocks may perform even worse if inflation rises suddenly.
How inflation affects stocks in the long run?
In the longer run, investment in stocks acts as a hedge against inflation. In high inflation periods, companies pass their costs to the consumer by increasing the prices. Because of this, the quantity of goods and services provided does not change, just their value increases. This increases the share price thus the investor’s money value. Yes, a sudden hike in prices may result in a fall in revenue. But in the longer run, when the company adjusts to inflation the profits resume.
How higher Inflation impacts the stock market?
We mentioned that during high inflation, companies pass the raising expenses to the consumers. But does that consumer buy the same product at a higher cost than earlier? Well, it depends on what type of product or good that is? If the product belongs to the luxuries category, the consumer may ignore it. But if those goods are essential like groceries, food, clothes etc., consumers buy them even at a higher price tag.
Humans prioritise their requirements based on the conditions. Growth and share prices of the companies depend on the consumer spending nature, priorities and requirements. So, a detailed analysis is required while picking stocks. Generally, most stocks fall under two categories either value or growth. Historically it is observed that during high inflation periods, the performance of value stocks is better than growth stocks. That doesn’t mean, you should allocate all your portfolio to value stocks. In investing, diversification is essential. In the long run, a diversified portfolio offers good returns by standing against all the ups and downs. To know more about value and growth stocks, consider reading – Value vs Growth Investing 101: The Essential Guide
How lower Inflation impacts the stock market?
During a low inflation period, interest rates will be less and there will be high money circulation in the economy. Because of easy money, consumer spending also increases. Companies take low-interest loans for their expansion. Simply, we can say that during a low inflation period, the economy expands.
Due to increased spending, companies show stronger revenues. As a result, the share prices appreciates. In lower inflation, the real returns will be higher. For example, if a company grows 10% and the inflation is 3%, the real growth would be 10% – inflation = 7%. In a low inflation period, the debts of companies and individuals increases.
Now we are at the end of our article – “How Does Inflation Impact the Stock Market?”. We have provided some key takeaways for easy understanding. Check our blog for more related articles.
- Inflation is a period in the economy during which the money value erodes. Consumer spending decreases and the overall economy slows downs.
- In the short term, inflation and stock performance are inversely proportional. That means, due to the rise in inflation, the share prices fall.
- In the long run, companies adjust themselves to inflation and the profits resume. When profits resume, the share value starts increasing.
- In the long term, stocks act as a hedge against inflation.
- During inflation periods, value stocks tend to perform better than growth stocks.