Investors, the Federal Reserve, and businesses continuously monitor and worry about the level of inflation. Inflation—the rise in the price of goods and services—reduces the purchasing power of each unit of currency.Rising inflation can be harmful: input prices are higher, consumers may lose purchasing power unless their incomes rise, and monetary policy measures to contain inflation can damage growth and employment.
Key Takeaways
- Rising inflation can be costly for consumers, stocks and the economy.
- Value stocks perform better in high inflation periods and growth stocks perform better when inflation is low.
- Stocks tend to be more volatile when inflation is elevated.
How Does Inflation Affect Stocks?
Inflation hurts stocks overall because consumer spending drops. Value stocks may do well because their prices haven't kept up with their peers. Growth stocks tend to be shunned by investors.
Inflation and the Value of $1
The chart below gives a sense of how dramatically inflation can reduce purchasing power.
This negative impact of rising inflation keeps the Fed diligent and focused on detecting early warning signs to anticipate any unexpected rise in inflation. The sudden increase in inflation is generally considered the most painful, as it takes companies several quarters to be able to pass along higher input costs to consumers.
Likewise, consumers feel the unexpected “pinch” when goods and services cost more.However, businesses and consumers eventually become acclimatedto the new pricing environment. These consumers become less likely to hold cash because the value over time decreases with inflation.
High inflation can be good, as it can stimulate some job growth. But high inflation can also squeeze corporate profits with higher input costs. This causes corporations to worry about the future and stop hiring, reducingthe standard of living of individuals, especially those on fixed incomes.
For investors, all this can be confusing, since inflation appears to impact the economy and stock prices, but not at the same rate. Because there is no one good answer, individual investors must sift through the confusion to make wise decisions on how to invest in periods of inflation. Some types of stocks tend to perform better during periods of high inflation.
Inflation and Stock Market Returns
Examining historical returns data during periods of high and low inflation can provide some clarity for investors.Numerous studies have looked at the effect of inflation on stock returns. Unfortunately, the studies have often produced conflicting results. Still, most researchers have found that higher inflation has generally correlated with lower equity valuations.
This has also been shown in emerging countries, wherethe volatility of stocks is greaterthan in developed markets. Since the 1930s, the research suggests that almost every country suffered itsworst real returns during high inflation periods.
Real returns are nominal returns minus inflation. When examiningS&P 500 returns by decade and adjustingfor inflation, the results show the highest real returns occur when inflation is 2% to 3%.
Inflation greater than or less than this rangetends to signal a U.S. macroeconomic environment with larger issues that have varying impacts on stocks. Perhaps more important than the actual returns are the volatility of returns inflation causes and knowing how to invest in that environment.
Growth vs. Value Stock Performance and Inflation
Stocks are often subdivided into value and growth categories.Value stocks have strong current cash flows more likely to grow slowly or diminish over time, while growth stocks are likely to represent fast-growing companies that may not be profitable.
Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest rates, growth stocks are negatively impacted far more than value stocks. Since interest rates are usually increased to combat highinflation, the corollary is thatin times of high inflation, growth stocks will suffer more.
What is Inflation?
Inflation is the rate of the broad general increase in the prices of goods and services over a period of time.
Why is Inflation Bad for Stocks?
Rising prices of goods and services injects uncertainty into the markets. During periods of rising inflation, corporations profit and growth margins may be hit, affecting investor confidence which in turn affects their willingness to take on risk by holding stocks.
Who Gets Hurt the Most During Inflationary Periods?
Usually those who are in the lowest income groups who spend the bulk of their income on essential goods will feel the paid of increasing prices the most.
The Bottom Line
Investors try to anticipate the factors that impact portfolio performance and make decisions based on their expectations. Inflation is one of the factors that may affect a portfolio. In theory, stocks should provide some hedge against inflation, because a company's revenues and profits should grow with inflation after a period of adjustment.However, inflation's varying impact on stocks tends to increase the equity market volatility and risk premium.High inflation has historically correlated with lower returns on equities.
Value stocks tends to perform better than growth stocks in high inflation periods, and growth stocks tend to perform better during low inflation.
FAQs
How Does Inflation Affect Stocks? Inflation hurts stocks overall because consumer spending drops. Value stocks may do well because their prices haven't kept up with their peers. Growth stocks tend to be shunned by investors.
How does inflation affect stock returns? ›
Rising costs and uncertain revenue growth can take a toll on corporate profit margins, and stock prices can fall in response. On a broader scale, high inflation creates unknowns about future interest rates. That uncertainty often contributes to market volatility.
How does inflation affect investment returns? ›
The rate of inflation represents how quickly investments lose their real value and how quickly prices increase over time. Inflation also indicates how much of a return investments need to make to maintain a specific standard of living.
How does inflation affect the rates of return? ›
You should take inflation into account in your investment strategy. Inflation reduces real returns on financial investments and erodes your purchasing power. In other words, your investments may be worth less when you need to use them. Inflation can affect different kinds of financial instruments differently.
What is the return of the stock market after inflation? ›
Average annual return of the S&P 500
Over the long term, the average historical stock market return has been about 7% a year after inflation. Looking at long periods of time rather than any one year shows something else—remarkable consistency.
What is the inflation adjusted return of the S&P 500? ›
The average yearly return of the S&P 500 is 10.47% over the last 30 years, as of the end of April 2024. This assumes dividends are reinvested. Adjusted for inflation, the 30-year average stock market return (including dividends) is 7.74%.
Will inflation hurt stock returns not necessarily? ›
Here's some good news: Inflation isn't necessarily bad news for stocks. A look at equity performance in the past three decades does not show any reliable connection between periods of high (or low) inflation and US stock returns.
What is the average return on investment after inflation? ›
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation. » Learn about purchasing power with the inflation calculator.
Is it good to invest during inflation? ›
Several asset classes perform well in inflationary environments. Tangible assets, like real estate and commodities, have historically been seen as inflation hedges. Some specialized securities can maintain a portfolio's buying power, including certain sector stocks, inflation-indexed bonds, and securitized debt.
How do you account for inflation in investment returns? ›
The real return on your investment will depend by the inflation rate. The real rate of return on your investment is calculated as: nominal rate of return – inflation rate. If the nominal rate of return of your financial investments is higher than inflation, the real return on your investment is positive.
Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers. When inflation causes higher prices, the demand for credit increases, raising interest rates, which benefits lenders.
Did prices go down after 70s inflation? ›
Eventually, aggressive monetary policy tightening in the late 1970s and early 1980s sharply reduced inflation in advanced economies and established central bank credibility, although often at the cost of deep recessions (Goodfriend 2007).
Do stocks go up or down with inflation? ›
Higher inflation typically drags down stocks as companies face higher wholesale prices to manufacture goods and consumers often are forced to spend more carefully. The S&P's price-to-earnings valuation is about 25% higher than it was in early 2020, when rates were below 2%.
How do you adjust stock returns for inflation? ›
Inflation-adjusted return = (1 + Stock Return) / (1 + Inflation) - 1 = (1.233 / 1.03) - 1 = 19.7 percent.
How much return on investment to beat inflation? ›
1 However, that figure masks a lot of variances. Baby Boomers might remember the 1970s when inflation rates hit double-digit rates. 2 In general, beating inflation requires a return on investment of at least 4% to 6% per year, in addition to whatever income is generated or saved for.
How does inflation affect dividends? ›
Finally, although inflation is uncorrelated to both dividend returns, and price returns in the short run, longer run evidence suggests that the Value equity style outperforms the Growth equity style in moderate to higher inflationary periods.
Is deflation good for stocks? ›
But when the rate of deflation increases, equity prices can begin to decline as people sell off equity investments that no longer offer satisfactory returns. The stock market can then weaken further, reflected by a dropping price/earnings ratio. Share might start to lose value as company earnings suffer.
Is high CPI good for the stock market? ›
Stock markets typically aren't moved as much by CPI data, but can be since higher interest rates can cause business activity to slow. In general stock markets prefer a lower CPI that allows consumers to keep spending, and business to continue investing.
What happens when inflation goes up? ›
Is Inflation Good Or Bad? Inflation is measured by the consumer price index (CPI), and at low rates, it keeps the economy healthy. But when the rate of inflation rises rapidly, it can result in lower purchasing power, higher interest rates, slower economic growth and other negative economic effects.
