How Inflation Affects Stock Investments

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Have you been noticing that things are costing more today? Inflation has been creeping up on the American economy.

In June 2021, the government announced that the consumer price index (CPI) increased 5% over the previous 12 months. This was the largest 12-month increase since a 5.4% jump in August 2008. Contributing to the uptick was a sharp rise in the index for used cars and trucks while food, household furnishings and operations, new vehicles, airline fares, and apparel also increased in cost. The CPI records the rate at which the prices for certain products go up.

Inflation tracks the rise in the price of goods and services, which in turn shrinks the dollar's purchasing power. When inflation rises, consumers can purchase fewer goods, input prices go up, and revenues and profits go down. As a result, the economy slows down until stability returns.

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.

You Could End up Overpaying for Stocks

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.

Earning Less When Inflation Decreases 

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.

The Impact of Inflation on Your Portfolio

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 buy 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% inflation. Look for inflation-indexed products like the Treasury I Bonds and other products that offer a hedge against rising rates.

Investors should keep an eye on interest-rate sensitive stocks.

Frequently Asked Questions (FAQs)

What if the stock market goes down during a period of inflation?

Stocks could be expected to take a hit when inflation spikes, but there are situations in which a prolonged economic downturn coincides with rising inflation. This is known as "stagflation." Stagflation is particularly challenging for lawmakers, central bankers, and economists because many of the tools they use to combat inflation depend on reducing economic growth. If the economy is sluggish to begin with, then it enhances the risks of those deflationary tools.

What are the best stocks for inflationary periods?

Since inflation increases the cost of goods, businesses with less reliance on raw materials could be expected to perform better than businesses with cost-intensive products. Blue-chip stocks may also perform better than growth stocks during inflationary periods because they carry less debt. Any rise in interest rates will increase operating costs for a company that depends on debt-fueled growth. Banks are on the other end of that equation—their profit on loans increases when interest rates rise.