The single topic I am getting the most questions about from clients recently is inflation. We’ve seen the discussion about discussing raising rates move the stock market, so let’s dive into why higher inflation is typically viewed as a negative for the stock market.
First, we need to understand why inflation can drag down the stock market. As inflation rises, we will see companies drop profitability. Costs of material and labor go up at a faster rate than consumers are used to their costs to purchase products or services rising. Borrowing money costs more. If you went to get a mortgage recently, you could have gotten a mortgage interest around 2.5%. If we see higher inflation, that same mortgage may cost home buyers 4%+. We also see a drop in standard of living. As companies raise their prices to match the hike in material and labor, your next car or trip to the grocery store will cost you more.
Now let’s turn our attention to the actual stock market. If we are aiming for an 8% return per year after inflation (this is an arbitrary number), and inflation was 2%, we would need a 10% return. If we still want that 8% return after inflation but now inflation is 4%, suddenly you need a 12% return to have the same inflation adjusted results. Pair that with companies’ earnings growth potential dropping and you begin to see the concern.
But the biggest concern with inflation isn’t inflation itself, it is rapid inflation. If we suddenly jumped from 2% to 4%, as in the example of the paragraph above, consumers and companies alike are not prepared. We see drastic changes in costs. When we see gradual inflation over a period of time, quite often our markets are able to move with the rate changes. In fact, gradual inflation can be a sign that our economy is growing.
Another thing for you as an investor to understand is that not all sectors are created equal when it comes to inflation. Growth stocks tend to underperform during higher inflation since their value comes largely from their future potential. Another potential area of underperformance can come from high dividend investments. If rates are rising, investors can begin to get a better yield from investments that are often considered more conservative. One area that has been stronger performance during rising inflation are more value-oriented stocks. We quite often see more consistent earnings — valuation based on what’s going on now in the company instead of far out in the future like growth stocks, and consistency in dividend income.
When considering inflation, be sure to understand your timeline, your level or proactivity, account types, tax ramifications of potential changes, and more to make sure you’re navigating the waters appropriately.