How Inflation Affects Stock Investments
Have you been noticing that things are costing more today? Inflation has been creeping up on the American economy. In November 2020, the government announced that the consumer price index (CPI) increased 1.2% in the previous 12 months. Contributing to the rise was an uptick in the cost of electricity and utility gas, medical care, housing and shelter (which includes housing and rent prices), and used cars and trucks. 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 percent 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.