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Inflation is the rise in the price of goods and services. When inflation increases, purchasing power declines and each dollar can buy fewer goods and services. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a measure of economic equilibrium is reached.

As a general observation through the years, value stocks tend to perform better in high inflation periods and growth stocks perform better during low inflation. When there is a high inflation, income-oriented or high-dividend paying stock prices generally decline. Moreover, stocks overall do seem to be more volatile during high inflationary periods.

According to analysts, the positive relationship with more cyclical oriented stocks probably hasn’t been abolished, but investors should make some allowance for increased volatility around data as they wrestle with an economy roaring back from an unprecedented sudden stop caused by the pandemic.

Higher inflation is usually looked on as a negative for stocks because it increases borrowing costs, increases input costs like materials and labor and also reduces standards of living. The bottom line is that rising inflation reduces expectations of earnings growth, putting downwards pressure on stock prices.

Unexpected inflation can create problems

Since the central banks want to keep inflation levels near to 2% a year, the stock market anticipates that there is a certain amount of inflation each year and adjusts what the expected returns should be against the expected inflation.

If, for example, investors expect a return of roughly 6% a year after inflation (including dividends), and inflation is 2% a year, investors will come to expect a roughly 8% return a year when inflation is factored in (this is in fact about the long-term return on stocks, over many decades).

On the other hand, in the case of inflation going from 2% to 4% very quickly for example, history indicates the overall market will react negatively.

That’s because investors will now demand a higher return to compensate for the now-higher risk. Instead of an 8% return, investors may demand a 10% return. Prices will likely drop.

How does it affect stock returns?

Most investors aim to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power.

If investors do not protect their portfolios, inflation can be harmful to fixed income returns, in particular. Many investors buy fixed income securities because they want a stable income stream, which comes in the form of interest, or coupon, payments. However, because the rate of interest, or coupon, on most fixed income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

Stocks have often been a good investment relative to inflation over the very long term, because companies can raise prices for their products when their costs increase in an inflationary environment. Higher prices may translate into higher earnings. However, over shorter time periods, stocks have often shown a negative correlation to inflation and can be especially hurt by unexpected inflation.

Conclusion

Inflation is one of those factors that affect a portfolio. In theory, stocks should provide some hedge against inflation, because a company’s revenues and profits should grow at the same rate as inflation, after a period of adjustment. In the U.S. market, the historical proof is noisy, but it does show a correlation to high inflation and lower returns for the overall market in most periods.
As mentioned above, when stocks are divided into growth and value categories, the evidence is clearer that value stocks perform better in high inflation periods, and growth stocks perform better during low inflation. One way investors can predict expected inflation is to analyze the commodity markets, although the tendency is to think that if commodity prices are rising, stocks should rise since companies “produce” commodities. However, high commodity prices often squeeze profits, which in turn reduces stock returns. Therefore, following the commodity market may provide insight into future inflation rates.

by Styliana Charalambous Head of Market Research
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