Inflation - how does it work and what does it do to the markets?? | Pints App

How Does Inflation Affect The Stock Market?

Investing in the stock market is a great way to build wealth, but it can also be a risky one. No matter how much you trust your broker or financial advisor, the fact is that even they do not have 100% read on the market. In addition to this, the stock market can also be very volatile and unpredictable. Like every other asset, stocks are prone to be affected by multiple factors. Since stock performance is an outcome of how the company’s business is doing, any changes there have a direct impact. Not to mention, there  are broader economic forces that affect the markets - like Inflation. And unlike the relationship between the company performance and the stock price, forces like inflation are not much in the company’s control.

Inflation is currently dominating the news cycles thanks to the constantly increasing prices of Gas, Food and airline tickets. This hurts us on a daily basis - as consumers and it also impacts our existing assets and investing decisions.

This article will explore some of the top reasons why inflation tends to negatively affect investing in general, as well as the ways that rising inflation might specifically affect your investments.

What is inflation?

Here’s what Investopedia says about inflation

Inflation is a measure of the rate of rising prices of goods and services in an economy. Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages. A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product.

While this seems rather straightforward, the causes behind why prices escalate are far from simple. A myriad combination of factors - supply side, gas prices, geopolitical tensions, trade barriers etc. can all contribute to inflation. But for keeping it simple, let’s just stick with the simple understanding - a general, sustained and unexpected increase in prices for goods and services.

Should you be concerned about Inflation as an Investor?

The most important way that inflation affects investing is the effect it has on your money's purchasing power. Think of it this way - in the 1970s, you were able to purchase a cup of coffee for 25 cents but in today’s situation, you’ll probably just be able to get a candy for it. The money you hold now may not necessarily mean you have the same power to purchase the same goods in the future. And this is why the Federal Reserve (the one who controls the US$) is so concerned about the rise of inflation because if our income does not match or be above inflation, many people would not be able to afford necessities. They are convinced that it is the worst-case scenario for the American economy - which is a 600 pound gorilla in the global financial order - and hence has repercussions for the global economy.

The main problem that comes from rising inflation is that it makes the value of money change over time. As it does so, that means that it becomes much harder to use it for almost everything without feeling like you are losing a significant amount of it in the process. The result - cost of almost everything will rise. This can affect the stocks in 2 ways

1. It could increase the company’s revenue in the short term - since they may be charging more for their products and services - OR
2. It could make things worse in the mid term - as people start getting conscious of prices and spend lesser, leading to demand contraction

So when you are investing in a company, inflation could have a mixed impact on the company’s performance. Add to it, are concepts of market bubbles - when assets get inflated and disconnect from the fair value of the company. But that’s for another day!

Inflation is OK, as long as it is expected.

Some inflation is good. Afterall, we expect the companies to grow and deliver a return. Normal inflation, within an expected range, is good for business and acts as a healthy incentive to grow. And that reflects in the stock market. What is bad is the unexpected or uncontrolled variety.

The way inflation impacts the stock market goes beyond just the direct performance of the companies itself. As an investor, one of the key decision factors to investing is the amount of return that is to be expected from buying a particular asset. For example, if the expected return from buying a particular asset is 5% and inflation is 3%, the total expected return is 8%, including the inflation.

Now suppose the inflation goes to 8% very quickly, then the overall expected return is (5% + 8%) 13%. If investors do not get that return from the asset in consideration, they will look elsewhere, leading to less demand in the markets and hence the stock market will face a downward pressure.

So what do you do, when inflation is out of control?

There is no magic bullet. But some lessons from the past hold true during the time of high inflationary periods that the global economy has experienced in the past.

One way of investing during inflation is Value Investing. Unlike Growth Investing (investing in stocks that are expected to deliver high growth in future e.g. tech stocks), Value Investing is a philosophy of identifying stocks whose market value is closer to its intrinsic value. Using fundamental analysis, investors can find good quality value stocks that have relatively low Price/Earning ratio and generate good cash flow. These tend to be (though not always) stocks of companies that sell products that are used on a regular basis (staples).

An investor can explore dividend stocks, small-caps, consumer staples, financial and energy - which have historically been more resilient in inflationary times. In the current situation, people who are tired of pandemic lockdowns are travelling, vacationing and are willing to spend on experiences - all sectors that were depressed for the last 2 years. And there are companies that are reaping the benefits of increased spending.

Real estate, Gold and other Commodities are also meaningful assets to consider. Whether it is REITs, sector focussed ETFs or mutual funds - these can be good places to invest.

Conclusion

In general, it is best to avoid investing in assets that will be directly affected by rising inflation. If you want to be sure that you are not negatively affected by rising prices, you should stick to low-risk investments that are less likely to be impacted by inflation. If you do choose to invest in inflation-sensitive assets, it is important to make sure that you are investing in high-quality assets that do not demonstrate a lot of volatility.

Finally, whatever the market conditions, it is important to diversify your portfolio. Many investors make the mistake of investing only in a handful of stocks, and all in the same sector. This may give a short term upside e.g. tech stocks in 2021, the impact on portfolio in times like these can also be outsized. Having a balanced portfolio with good quality investments is usually the best long term defence against cyclical downs.

Read more: What stops young people from investing? And how to overcome the obstacles