Inflation has been in the news lately, and even if you haven’t heard about it there, you’ve probably seen its effects at the grocery store, the gas station and lots of other places. But what is inflation, exactly, and how does it affect stocks? Here’s what you need to know.
What Is Inflation?
Inflation is simply the increase in the price of goods and services. The International Monetary Fund goes into a little more detail when it goes on to say, “Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year.”
The distinction of inflation over time is important. When you hear inflation described in the news, you’ll sometimes hear things like, “inflation was up 9.1% in June.” This does not mean that prices in June were 9.1% higher than they were in May. Inflation figures are typically compared to the same period a year before. So, while prices didn’t go up 9.1% from May to June, they did go up 9.1% from June of the previous year.
Inflation and Interest Rates
When prices go up, the government often tries to stem the tide of inflation by raising interest rates. The recent housing market is a good example of how this works.
During the COVID-19 pandemic, housing prices rose as people exited crowded cities for the relative safety of less congested suburbs. This created increased demand for homes, which drove up prices. Many sellers received multiple offers the day they listed their home for sale, and bidding wars ensued, with buyers paying more than the asking price — sometimes a lot more.
But there are two factors that influence the purchase of a home — the selling price and the interest rate. Buyers have to take both into account to determine whether they can afford a given home. When rates go up, a home becomes more costly. Since fewer people can afford expensive homes and a high-interest rate mortgage, demand slows down. This causes prices to fall.
Other purchases are also affected by interest rates. When you buy something on a credit card, that credit card typically has a variable rate of interest. When interest rates go up, your credit card company can — and usually does — raise the interest rate they charge you on any balance you don’t pay off at the end of the month. So that dinner you charged might cost you a little more over time if the interest rate is rising.
How Will Inflation Affect Stock Prices?
Companies face a double whammy when it comes to inflation. With interest rates rising, it’s more expensive for them to borrow money, which they may need to do in order to purchase the materials they need to make the products they sell. At the same time, consumers are buying less, so the companies may be forced to drop their prices.
Eventually, things will even out as supply and demand get back in sync, interest rates moderate and inflation calms down. But until then, you can expect quite a bit of volatility in the stock market.
What Should You Do?
Generally speaking, value stocks tend to do better in inflationary times than growth stocks. So, look for stocks that have a low price to earnings, or P/E, ratio relative to their peers. These are stocks that would be considered undervalued, and therefore more likely to have better returns than their competitors.
Some investors think that it’s a good idea to move some money into cash when inflation is high. And while it’s true that interest rates are going up, they are still not keeping pace with inflation, which is also rising. So going to cash is not much of a hedge when inflation is on the rise.
Are Stocks Good During Inflation?
Stocks can be a good investment during inflation because inflation reduces buying power, making cash worth less. So, inflation can represent a buying opportunity for a patient investor willing to do their homework.
It takes some finesse to find stocks that will hold up well as inflation rises, but looking for undervalued companies is a good place to start.
Do Stocks Go Up or Down During Inflation?
Just like any other time, some stocks will go up and some will go down when inflation is rising. To find stocks that are more likely to go up in inflationary times, look for companies that make products that consumers will continue to buy even if they become more expensive.
These so-called “defensive” stocks can include consumer staples like food, beverages and household goods; healthcare companies, like health insurers and manufacturers of health products; and utilities like electricity, oil and gas.
What Happens Next?
Even though prices tend to rise over time, rapid inflation can’t go on forever. Eventually, the interest rate is raised enough to cause consumers to cut back, decreasing demand and causing a commensurate decrease in supply. Unfortunately, this can result in a recession, especially if there is high unemployment.
A recession is defined as two or more consecutive months of negative gross domestic product, or GDP. This means that for at least two months in a row, the country produces less than it did the month before.
In a recession, as in times of high inflation, defensive stocks may have the best outlook. Again, these are companies whose products are necessary, and consumers will continue to buy them even if they can’t afford to buy other things.
For example, if prices rise to the point where a consumer has to choose between buying groceries and going on vacation, they’re going to opt to feed their family. This is why a grocery store stock may fare better during inflation or a recession than a cruise ship company.
Even if inflation continues to the point where a recession occurs, both the inflation and the recession will eventually moderate. At some point, we’ll be back to having a booming economy — until the next time. This is the nature of the economic cycle. You can’t stop it, so it’s best to be prepared for it.