The Impact of Inflation on the Stock Market: Should You Adjust Your Investment Strategy?

May 8, 2023

9

min read

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s an investor, you're not just investing your money; you're also investing your purchasing power. You're essentially sacrificing the ability to buy 100 apples today in hopes of being able to purchase 200 apples later. But what if the inflation monster shows up and eats away all your purchasing power, leaving you only enough money to buy 50 apples? This is a sad reality that many investors face.

Thus, you must understand the impact of inflation on the stock market and adjust your investment strategy to protect yourself and your stock returns.

Inflation Driving Stock Prices Down — Source: Freepik

Understanding Inflation

Before diving into the main issue, let's discuss inflation and its causes.

What is Inflation?

Inflation is the increase in the general price of goods and services, resulting in decreased purchasing power and value of money. Simply put, if you could buy a pen for $1 and, due to inflation, the pen now costs $2, your $1 can no longer afford to buy that pen.

In this way, inflation erodes purchasing power and weakens the currency's value, increasing living costs.

What Causes Inflation?

Various factors can cause inflation, but two key players are demand and supply.

Demand-related Factors: When the economy is good, and people have enough money, they can afford things, and this causes an increase in demand for goods and services. As demand increases, so do the prices, causing inflation.

Supply-related Factors: Inflation rises when there is less supply of goods and services to fulfill the existing demand. The shortage may be caused due to supply chain issues, pandemics, or wars. When supply can't keep up with demand, prices rise as people are willing to pay more to get what they need.

In some cases, demand and supply may both contribute to inflation. For example, there is an increase in demand for the product but a decrease in supply. This can lead to a vicious cycle, where a shortage in product drives to even high demand driving up prices even further.

Impact of Inflation on the Stock Market

Although a complex relationship exists between inflation and the stock market, historical evidence suggests that inflation results in falling stock prices. Here’s how it impacts the stock market:

Impact on Companies' Profits

Inflation may seem to increase the company's profit since the price of goods and services increases. But, here is the thing: inflation also means the rise in the costs of raw materials, labour, and production inputs, and when that happens, the company has two options:

Pass the increased cost to the customers through the increased price.
Treat the increased cost as its own expense resulting in less profit margin.

Ultimately, both options result in low-profit margins, as increasing prices might lead customers to switch to cheaper alternatives. As a result, inflation reduces the company's profit, and since companies earn less profit, their stock prices decrease.

Impact on Consumer Spending

Inflation can be a nightmare for consumers as it eats up their purchasing power and increases the cost of living. As a result, they must cut back on their discretionary spending to make ends meet. Since people spend less, businesses have less revenue and profit, ultimately declining stock prices.

Impact on Foreign Exchange Rates

High inflation also weakens the power of the currency. Thus, if a country suffers from high inflation, it devalues the currency and impacts the foreign exchange rate. This can impact the profit of multinational companies that earn revenue in foreign currencies and return for the foreign investors who invest in the international stock market.

Impact on Interest Rates

While inflation has some impact on the stock market, rising interest rates can have a much more significant impact on stock prices. Interest rates and inflation are intertwined, with interest rates being a powerful weapon used by Fed to combat rising inflation. But rising interest rates are a foe to the stock market. Here’s how rising interest rates impact the stock market:

Since the interest rate for borrowing is increased, the companies have to pay back more interest on the loans causing less profit reflected in low stock price.
Since the interest rate is high, investors can earn high-interest rates in low-risk fixed-income securities. So this reduces the demand for stocks, thus, causing the stock market to fall.
Rising interest rates also decrease consumer spending as it becomes expensive for consumers to afford goods since they have to pay more interest. This impacts the profitability of companies relying on consumer spending.

Which Sector of the Stock Market Takes the Hardest Hit?

While inflation hits all the sectors, specific sectors of the stock market are most affected by inflation, which are as follows:

Negative Stock Returns — Source: Freepik

Consumer Discretionary

In times of inflation, since people tend to prioritize meeting their needs, so they cut off discretionary spending. As a result, consumer discretionary company takes a significant hit. With the low demand, the company is also facing higher costs which can lead to lower profits if they can't pass these costs onto consumers through higher prices. Thus, the profitability of these companies takes a hit, causing their stock prices to drop.

Mortgage REITs

Mortgage REITs that invest in the mortgage are most affected by the high inflation. This is because the high inflation is followed by high-interest rates causing an increase in mortgage rates.mREITs typically rely on borrowing money at short-term rates to invest in longer-term mortgages. If interest rates rise, the cost of borrowing for mREITs can increase, impacting their profitability.

Financial Companies

Financial companies are not immune to the impact of inflation. Higher interest rates caused by inflation can cause a high risk of default risk. Also, it can erode the value of fixed-income investments, further affecting the profitability of financial companies.

Tech Companies

With increased costs on households, tech companies see a lower level of demand for their product and services. Since the purchasing power of people has been eroded by inflation, people simply cannot afford to buy the latest gadgets. This decreases the demand and overall profitability of tech companies.

Overall, when it comes to inflation's impact on the stock market, it's a game of high prices and low profits, and those sectors which cannot handle them are most impacted.

Smart Investment Strategies to Navigate Record-High Inflation in the Stock Market

Here's the general rule in investments, one's loss is another's gain. Thus, some sectors benefit from the high inflation, and some are inflation-proof. Here are some strategies to reap benefits in record-high inflation as well:

Invest in Inflation-Resistant Sectors

Specific sectors, such as energy, materials, commodities, and real estate, tend to perform well during inflation as they can pass on higher costs to consumers. These sectors may benefit from rising prices and interest rates, as they often have stable cash flows and long-term contracts that can provide a hedge against inflation.

Invest in Companies’ Stock With a Pricing Power Advantage

Consider investing in companies that can raise prices without consequences during the inflationary period. These companies often have a competitive advantage, such as a monopoly or fewer competitors in the market. For example, Apple can quickly increase its prices without resistance as no direct competitor offers the same products and services. This helps in maintaining profitability despite the inflationary environment.

Rising Stock Performance — Source: Freepik

Diversify Your Portfolio

Diversification is a crucial investing strategy but is much more critical during inflation. You should invest in a mix of stocks, bonds, real estate, gold, and other assets such that it helps in balancing and mitigating the risk and protects your portfolio against inflation.

Look For Undervalued Stocks

The best time to invest in stocks is when they are falling. This allows you to buy quality companies' stock at a lower price. Since the market is falling, panic selling creates market inefficiencies. But, by identifying undervalued stocks that are likely to perform well over the long term, you can potentially achieve better returns.

Searching for the Best Stocks — Source: Freepik

Use Dollar-Cost Averaging

When the market is volatile during high inflation, buying or selling stocks all at once can be tempting. However, a smart strategy is to use dollar-cost averaging. This means buying or selling stocks in smaller increments over time. By doing this, you can avoid the risk of buying or selling at the wrong time due to market fluctuations. Plus, you can achieve better returns over the long term by taking advantage of the variations in stock price.

Consider Short-selling

Since stock prices are likely to be negatively impacted by rising prices, there are opportunities to profit from short-selling stocks. Short selling is like betting that a stock will decrease in value. But, it’s important to remember that short selling is a very risky strategy and should be only undertaken if you are highly experienced and confident.

Hold and Wait

One fundamental truth about the stock market is its cyclical nature. So, if the stock market is decreasing today, it will rise. With a long-term investing strategy, you must maintain a long-term view and avoid reacting to short-term market fluctuations.

Does the Fed Manage Inflation to Control Stock Market Performance?

Federal Reserve does not manage the stock market, but its policies can indirectly affect its performance. The stock market is a free market determined by demand and supply.

What the federal reserve is always on the lookout for is increasing inflation, as it has a serious impact on the economy. Thus, to combat the rising inflation, it increases interest rates to reduce the money supply and slow economic growth.

Characters Analyzing Stocks — Source: Freepik

But, the stock market has an inverse relationship with the interest rate. As the interest rate increases, investors are more attracted to bonds and other fixed-income investments that yield higher returns at lower risk. This may lead investors to shift away from the stock market, where there is high risk.

Conversely, when inflation is low, the Fed may lower the interest rates to stimulate economic growth. Lower interest rates can make borrowing cheaper, increasing investment and spending and supporting the stock market's performance.

While the Fed's policies can indirectly impact the stock market, they are just one of many factors that can affect its performance.

Long-Term Strategies to Protect Against Inflation

Here are strategies you can adopt for the long term to invest in stocks that can protect against inflation over time:

Invest in Companies With Pricing Power

Investing in inflation-resistant companies is the best way to protect against inflation. These companies generally can raise prices over time and have no issue passing the increased cost to their customers without any consequences. Thus, investing in companies with a competitive advantage, strong brands, and loyal customers helps you protect against inflation.

Avoid Speculative Investments

It's crucial to avoid speculative investments that are likely highly volatile and subject to wide swings in value. These investments can be especially vulnerable to inflation, as economic changes can significantly impact their performance.

Focus On Dividend-Paying Stocks

Dividend-paying stock can give you a reliable source of income that helps you keep up with inflation over time. Additionally, the companies that consistently pay dividends have solid financial profiles and stable earnings and profits.

Finding Dividend-Paying Stocks — Source: Freepik

Invest in Index Funds

Investing in index funds during inflationary pressure is also a great strategy. These funds track a broad market index, such as the S&P 500, and provide exposure to various companies. Over time, the returns from these funds have typically outpaced inflation and can be an excellent tool for investment during high inflation periods.

Consider Using Inflation-Indexed Securities

Inflation-indexed securities such as Treasury Inflation-Protected Securities (TIPS) can provide a hedge against inflation.TIPS adjust their principal value in line with changes in the Consumer Price Index (CPI), which means that they help maintain your investment's purchasing power.

Consider Investing in Real Assets

Real assets such as real estate, gold, and other commodities tend to hold their value during inflationary periods. Investing in these assets can hedge against inflation and help maintain your portfolio's purchasing power.

Investing in Real Estate — Source: Freepik

Invest in Growth Stocks

Growth stocks are companies expected to grow faster than the overall market. These investments can achieve better returns over the long term and may better weather inflationary pressures.

Consider a Balanced Portfolio

A mix of stocks, bonds, and other asset classes can provide a good balance of risk and return over the long term. By diversifying across different asset classes, you can reduce your overall risk and achieve better returns over time.

Consider Defensive Stocks

During periods of high inflation, you may want to consider investing in defensive stocks. These companies are less sensitive to economic changes and are more likely to weather market volatility. These stocks add a little certainty to your basket that you know not all your investments are plummeting.

Conclusion

Inflation can have a significant impact on your stock market and returns. However, by investing in companies with pricing power, diversifying your portfolio with inflation-indexed securities and real assets, and avoiding speculative investments, you can build a portfolio that can withstand inflationary pressures and maintain its value. To sum it up, inflation is a big monster we cannot beat, but with the right investment strategy, we can protect ourselves from its rages.