How Does Inflation Affect the Stock Market? - Lightspeed

How Does Inflation Affect the Stock Market
Written bySusan Livson
Published on18 January 2024

What is Inflation?


Inflation is the rate of increase in general prices for goods and services over a gradual period. When inflation occurs, the purchasing power of currency decreases and the same currency unit cannot purchase its previous quantity of goods or services. As a consequence, prices rise and cause decreased spending by consumers.


The economy is usually expected to experience moderate inflation (1-3%), indicative of economic growth. Here, the value of the dollar and prices of goods and services remain relatively stable. However, when inflation rises above this desired level, the Federal Reserve hikes interest rates, making borrowing money more expensive. This, coupled with rising prices, keeps consumers from purchasing goods and services. Although this tactic seeks to lower consumer spending to decrease the demand for goods and services, it also hurts the economy when consumers have less purchasing power.


Why Does Inflation Affect the Stock Market?


When inflation rises, stock prices generally fall because consumers are usually spending less. Thus, inflation affects the stock market because when company profits decrease (from reduced sales) stock prices are negatively impacted. Additionally, the borrowing rates from the brokerage rise, making it more expensive and risky to trade. Investors also may be more conservative in their trades because of the volatility of the market. It is important to note that inflation can affect stocks differently depending on whether they are long- or short-term holdings.



Inflation and stocks in the long- and short-term


Long-term


Long-term holdings can be beneficial during a period of high inflation. This is because even though cash has depreciated, the real monetary value of a stock appreciates and can (when inflation goes down) be used for higher purchasing power in the future.


Short-term


The short-term effects of inflation on stocks are not as favorable because, as previously mentioned, stock prices generally decrease as inflation rises. Therefore, you may need to hold the stock until inflation is controlled to see it appreciate. In the meantime, investors would need to make a higher return during a period of high inflation to see a real return on the stock portfolio. Additionally, higher interest rates make it more expensive to borrow funds from the brokerage and thus hinder the ability to invest further.



How Inflation Affects Types of Stocks


Inflation has different effects depending on the type of stock you are holding: Value stocks are desirable when inflation is high, and growth stocks are desirable when inflation is low.


Value Stocks


Value stocks are investments that trade lower than their actual value. This is because they are based on a stock’s potential outlook rather than its current value. These potentially perform better during periods of high inflation because their returns are based on a long-term investment that has the potential to yield returns later on. They also offer the possibility of dividends because the company typically doesn’t have a high need for free capital. Because they cost less than this future value, they may be a good investment choice during economic downturns.


Growth Stocks


Growth stocks are securities that are expected to have an increased growth rate. These usually perform better when interest rates are low, and therefore would not be desirable during periods of high inflation. Their success is also attributed, in part, to a company’s ability to borrow cheap capital used for aggressive reinvestments, and thus would not be as lucrative when borrowing ability is stunted during high inflation.



Conclusion


Ultimately, inflation has various impacts on financial markets. These long- or short-term effects are contingent on the type of security and should be considered when making investment decisions.




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