In the aftermath of the Covid pandemic and geo-political tensions, high inflation became a global problem. While it affected everyone to some extent, it became an obsession among investors, who became strongly concerned about the economic impact of rising prices and their potential impact on the stock market. While elevated inflation doesn’t necessarily spell disaster for investors, the fact remains that it has severe negative consequences for the broader economy.
The post-Covid inflation has already peaked, and the reaction of the US Federal Reserve has strongly contributed to regaining control of the situation. However, the increased prices will likely remain a problem for the stock market for an extended period of time. In this guide, we will explain why.
How does inflation work?
In the US, for example, the Fed aims for a long-term target of 2% annual inflation growth. If the inflation rates exceed this figure and run too high for an extended period, this is a bad signal for the economy. It signals that the demand is higher than the supply, increasing the prices of various products on the market. This can also happen when the supply chain is disrupted during the pandemic.
In both cases, the rising prices affect the consumers’ ability to buy, and spending suffers a severe decline. This leads to an overheated economy and could potentially even lead to a recession.
What are the two types of inflation?
The key factors that affect the rate of inflation are supply and demand. From this, two types of inflation can emerge:
- Demand-pull inflation: This is a more common type of the two, which is caused by increased demand that outstrips the supply. When people want more goods and services than the market can supply, the prices of available goods and services grow.
- Cost-push inflation: This type of inflation happens when the supply chain for goods and services is disrupted. In this scenario, the demand remains relatively unchanged. However, due to disruptions in the supply chain, the supply of goods and services declines. This type of inflation requires a world-affecting event, and it was most recently seen during the COVID-19 pandemic.
How does inflation affect the stock market?
While it is undeniable that inflation affects the stock market, its impact is not actually direct. Ideally, the stock market aims to see sustained growth in prices that is considered healthy when it is between 1% and 3%. In this situation, the value of the dollar remains stable, the demand and supply are steady, and the prices remain consistent and predictable.
However, if inflation exceeds this level, it immediately leads to uncertainty in the stock market. Consumer spending starts to slow, and the prices of stocks become volatile. This causes the economic growth to slow, while valuation concerns tend to lead to a weaker performance in the stock market.
While the studies involving inflation’s impact on returns have produced conflicting results, researchers agree that high inflation causes lower equity valuations. Consequentially, such a volatile market tends to be riskier for investors, which is why the investments tend to drop, and this drop in demand also leads to a drop in share prices.
How to deal with high inflation?
Higher inflation is not necessarily bad for stock prices, but once inflation starts getting out of control, the authorities need to deal with it in order to maintain order and economic stability. This leads to an increase in interest rates, which has a more severe impact on the stocks.
Higher interest rates have been the best and most efficient remedy for higher interest rates, but they also make credit more expensive for consumers and companies. As a result, many are discouraged from engaging in investing and spending alike. The consequence is a drop in profits for the companies, which causes poorer performance, and further hurts stock prices.
Which stocks suffer the most from high inflation?
The rise of inflation rates, followed by the rise of interest rates, can leave the market in bad shape. However, some stocks tend to be more resistant to the negative impacts of elevated inflation than others.
- Growth stocks are very sensitive to interest rate hikes. Financial analysts and fund managers use discounted cash flow models to value a company’s future earnings. With the interest rates going up, these models assign less value to the stock’s future cash flow. Growth stocks tend to represent fast-growing firms that might not yet be profitable.
- Value stocks, on the other hand, have a strong current cash flow. As such, they are more likely to grow slowly. This makes them more resistant to negative impacts from interest rates.
This does not mean that value stocks are immune to the effects of growing interest rates, but they are more resistant and somewhat safer to invest in during such difficult economic periods.
Increased inflation can lead to difficult economic periods and affect anything, from stock prices to the cost of living. However, its impact on the stock market is indirect, so inflation rates’ impact on the stock market is hard to predict.
Interest rates have a much stronger effect, but they are still necessary in order for the authorities, such as central banks, to regain control of the market and stabilize the economy.
Of course, inflation also has long-term consequences, and their severity has yet to be determined. Right now, the inflation that came as a consequence of the pandemic is believed to be past its peak, but its effects will likely be felt for several years to come.