Inflation is a major topic for economists and savvy investors.
In short, it refers to the rate at which prices are increasing across the economy.
It’s why something like a sandwich might cost $3 one day, but creep up to $3.10, or $3.50, or even more over time.
One day, things might even get to the point where even $5 isn’t enough to buy lunch.
It sounds terrible, but it’s not all bad.
In fact, it’s very normal-inflation is a critical part of any functioning economy, with a rate of around 2% or less generally considered acceptable.
It’s when it moves too far above this line in the sand that problems really begin to arise.
Indeed, this can quickly lead consumers to find that their money has much less purchasing power than it did before, meaning their disposable income cannot stretch far enough.
Likewise, it can also lead to higher interest rates. That means taking out a loan can quickly become less affordable
And the problems for companies are similar, but typically on a much larger scale.
You see, inflation increases the cost of materials and labor and makes borrowing money for business development increasingly difficult.
Not only that, but if it rises too quickly, then it can take time for companies to pass rising costs on to consumers, which hurts performance.
It’s for these reasons, which we’ll go into more detail here, it’s important to factor inflation into stock market investing.
In fact, as you’ll see, failure to take rising prices into account can add serious risk to one’s asset allocation decision.
The opposite of inflation is deflation. Deflation often occurs when economic conditions are poor, as people cut back on spending. Deflation also hurts individuals with debt, as that debt gets more expensive to pay off when money is worth more.
How inflation affects different types of stocks
Different types of stocks behave differently when it comes to inflation. Not only that, but investor expectations also play a big role, as well as wider economic impacts.
Inflation and growth stocks
Growth stocks are stocks that are not currently making as much money as the market believes they will over the long term when they reach their potential.
These kinds of stocks take much more of a hit from inflation. And, in part, this is because of the impact of rising prices on interest rates.
You see, while inflation might initially seem like a good thing for borrowers, since a drop in the value of a currency means it gets cheaper to repay the debt over time, it isn’t—unfortunately—that simple.
Instead, inflation is eventually met by an increase in interest rates, as governments want to cool spending by making saving more attractive. In turn, this makes borrowing more expensive.
Since growth stocks often have limited to no cash flow at present—their outperformance is regularly driven by investors buying into their potential rather than their current reality—they are most in need of credit.
So, if inflation has led to higher borrowing costs, these firms can find themselves at risk of either being unable to secure funding or service their interest rate repayment obligations.
Still, it all depends on the context within which prices are rising.
Indeed, when inflation occurs while the economy is weak, for example during a recession, growth stocks take a much harder hit from inflation. But if the economy is doing well, higher inflation is less damaging thanks to the positive underlying spending and lending environment.
Inflation and value stocks
In the case of value stocks, cash flow is normally strong but—whether rightly or wrongly—expected to slow down as time goes on.
Unlike growth stocks, value stocks weather inflation well, and often perform better amid higher inflation.
Much of this comes down to the status of these value stocks. Often, they are mature businesses.
The appeal of value stocks, then, is that investors can see returns straight away. Higher inflation means investors would rather think short-term and choose value stocks, instead of waiting on a growth stock to deliver in the future.
Inflation and income stocks
Income stocks are those that pay regular, reliable dividends. As dividend levels tend to lag behind inflation, these kinds of stocks lose value as inflation rises.
After all, the value of dividend payments shrinks as inflation rises.
A dividend of $0.30 per share might start off sounding pretty good, but would seem less so over time as the value of those 30 cents started to shrink with high inflation.
For this reason, then, the charms of regular dividends diminish when inflation increases.
The worst incidence of the phenomenon known as hyperinflation took place in Hungary in 1945. The government started printing money at a frantic rate in a bid to stimulate the economy after WWII. The highest inflation rate seen during the hyperinflation period was 13,600,000,000,000,000% – that’s thirteen quadrillion six hundred trillion percent.
Inflation and hedging
Hedges are investments made with the goal of limiting risk.
When inflation is high, investors often turn to tangible assets like precious metals and property, which are seen as a hedge.
Gold is probably one of the most well-known hedges against inflation. When inflation drives down the value of the US dollar, the gold price typically increases.
There are multiple reasons for this. One is that investors often prefer to hold the precious metal than to hold US dollars when the value of those dollars is going down.
For this reason, gold is considered a ‘safe haven’.
That means investors expect the value of the yellow metal to gain value when markets become more chaotic and unpredictable – such as periods of high inflation.
Advantages of inflation for investors
One advantage of inflation for investors is that is can become cheaper to buy certain types of shares, like growth and income stocks.
In periods of high inflation, investors find promises of future returns – which are never a guarantee – less compelling than the more immediate returns of value stocks.
This makes it cheaper to buy growth stocks, which could appreciate considerably in the long term.
Given this, investors can turn these high inflation periods to their advantage and snap up bargains that might have seemed out of reach before.
Avoiding deflation and incentivizing investment
A small amount of inflation also helps avoid the perils of deflation, which can be damaging to economies and businesses.
In fact, to avoid deflation, policy makers typically accept some amount of inflation as being necessary to avoid deflation – typically that 2% previously mentioned.
Economists tend to fear deflation much more than inflation, accepting a small amount as necessary to stimulate growth.
If money sits around without being spent or invested, it loses value, so inflation is also an incentive for people and businesses to use money rather than hoarding it under the floorboards.
This, in turn, stimulates the economy and ensures that everyone keeps spending and investing.
In small doses, the reduction in the cost of debt over time due to deflation can also prove beneficial for borrowers.
If inflation rises, the value of debt decreases and it becomes cheaper to repay.
However, the benefits of inflation for investors can vary depending on interest rates.
Disadvantages of inflation for investors
High inflation can come along with greater volatility and uncertainty. Hyperinflation, for example, can create chaos and undermine the value of an entire currency.
While this kind of runaway inflation is rare, unusually high inflation can still have detrimental effects on investments – eroding the value of dividends and shrinking the value of growth shares.
It is important for investors to keep an eye on inflation, ensuring they know when inflation is rising and can act. This might be through hedging, or shifting focus to value stocks.
Lower investment returns
Investment returns have to keep up with inflation to have any hope of increasing an investor’s actual purchasing power.
Even the accepted 2% inflation level means that any investment returning less than 2% is, in fact, delivering a negative return when you adjust for inflation.
If inflation proves unusually high, it would become more difficult for investment returns to beat inflation.
Inflation begets inflation
As inflation pushes people to spend and invest, it can trigger even more inflation. This is because companies and individual investors try to spend as fast as possible so they are not holding onto a currency that is losing value.
Since all this spending is happening, more money ends up in circulation, which makes it even less valuable. In this way, the cycle of inflation continues.
For this reason, inflation must be kept in check to avoid this runaway effect.
Where’s the Value?
- It’s not all bad – at normal levels, inflation can be a good thing. It increases spending and investment, making it part of a healthy economy.
- Think long term – it is also worth accepting some amount of inflation in order to avoid the threat if deflation.
- Beware the dangers – too much inflation is definitely dangerous – rapidly devaluing currency and causing serious upheaval.
- moderation is key – investors should be wary of inflation and its risks, while trying to make the most of its benefits.