Learn How Inflation Affects Stock Investments

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The stock market is being stalked by the “I” word, and investors are showing their nerves. Inflation has the Federal Reserve Board on alert, and the implications are widespread.

Factors that are lining up like some ill-fated stars to guarantee the Fed will continue raising short-term interest rates include high energy prices, rising wages, and increasing housing costs

High-interest rates and companies raising prices don't add up to an investment profile most investors enjoy. However, stocks are still a good hedge against inflation because, in theory, a company’s revenue and earnings should grow at the same rate as inflation.

The Role of Global Markets

While some companies can react to inflation by raising their prices, others who compete in a global market may find it difficult to stay competitive with foreign producers that don't have to raise prices due to inflation.

More importantly, inflation robs investors (and everyone else) by raising prices with no corresponding increase in value. You pay more for less.

This means that a company's financials are overstated by inflation because the numbers (revenue and earnings) rise with the rate of inflation, in addition to any added value generated by the company.

Earnings Are Affected

When inflation declines, so do the inflated earnings and revenues. It is a tide that raises and lowers all the boats, but it still makes getting a clear picture of the true value difficult.

The Fed's chief inflation-fighting tool is short-term interest rates. By making money more expensive to borrow, the Fed effectively removes some of the excess capital from the market.

Too much money chasing too few goods is one classic definition of inflation. Taking money out of the market slows the cycle of price increases.

Given the pressures mentioned earlier, you can take it to the bank that the Fed will keep raising rates.

Investments

Should you be concerned about inflation and your investments? If you have a substantial portion of your portfolio in fixed income securities, the answer is a definite yes.

Inflation erodes your purchasing power, and retirees on fixed incomes suffer when their nest eggs buys less each passing year. This is why financial advisers caution even retirees to keep some percentage of their assets in the stock market as a hedge against inflation.

The more cash or cash equivalents you hold, the worse inflation will punish you. A $100 under the mattress will only buy $96 worth of goods after a year of 4 percent inflation. Look for inflation-indexed products like the Treasury I Bonds and other products that offer a hedge against rising rates.

Conclusion

Investors should keep an eye on interest-rate sensitive stocks, since continued pressure by the Fed will keep rates moving up.