How does inflation affect the stock market?
The link between inflation and stocks is complex and each stock should be evaluated on its own merits. Find out how inflation affects the stock market – both in the long term, as well as the short term.
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Inflation – the need to knows
Inflation measures the rate at which the purchasing power of money erodes over time. Money acts as a unit of account, a medium of exchange and as a store of value. As a store of value, money’s purchasing power is entirely dependent on price levels. As prices inflate, each unit of money becomes increasingly less valuable.
Money isn’t unique as a store of value – people often choose to hold wealth in other assets like stocks, bonds and property. However, these assets generally have to be converted into money before the wealth that they hold can be exchanged for other goods and services.
The negative effects of inflation are easy to see. The loss of real income – income measured as a collection of goods and services rather than a nominal currency amount – for those on fixed incomes is particularly pronounced. Moreover, because people need to hold some wealth in money for transactions and unforeseen expenditures, inflation ultimately acts to diminish this portion of wealth until wages increase.
On the upside, however, stable levels of inflation are correlated with lower unemployment (this could be because expected higher prices stimulate business investment, or because the demand for consumer goods and services has surged).
Additionally, many economists argue, a low level of inflation (between 1% and 3%) is needed for monetary policy to be effective. Lastly, borrowers stand to benefit from inflation when holding fixed-interest rate loans: higher inflation means a lowered real cost of borrowing.
What does higher inflation mean for stocks?
Unfortunately, the relationship between inflation and equity prices is not straightforward, and no catch-all rule can be applied. A prudent investment or trading strategy would require a thorough analysis of the specific characteristics of each stock under review.
With this said, prevailing wisdom indicates that there are certain guidelines that could help in such an analysis.
Inflation and stocks in the long run
For stock investors, shares can act as a hedge against inflation in the long run. This means that the monetary value of a stock or share portfolio can appreciate over an inflationary period so that the ‘real’ wealth it stores – the goods or services it can be exchanged for – remains constant despite higher prices.
In the case where inflation stems from higher input costs (known as cost-push inflation), for example, once businesses have had enough time to adapt to the inflationary pressures and to adjust their own prices, revenues will increase and normal profit rates may resume.
The higher input costs are simply passed on to consumers after a period of price revision. The economic logic here would also imply that this is probably more realistic for a well-diversified portfolio rather than an individual stock that carries its own idiosyncratic risk.
Inflation and stocks in the short run
Analysts suggest that the short-term dynamic is less favourable, and that the relationship between equity prices and inflation is (quite frequently) an inverse correlation – ie as inflation rises, stock prices fall, or as inflation falls, stock prices rise. The adverse effect of inflation on stock prices in the short term could result from a range of factors, including:
- Falling short-term revenue and profits creating a drag on share prices
- A general economic slowdown, resulting in an unfavourable macroeconomic environment for the stock market and consumer spending in general
- A monetary policy response that induces higher short-term interest rates, causing investors to substitute stocks for lower priced bonds
- The prospect of lowered, or even negative, real returns lowering the demand for equity investment. In inflationary environments, investors need to make higher returns from a stock portfolio to ensure a positive real return. For example, if you make a 4% gain from your portfolio yearly, that’s a real return of 3% when inflation is 1%. But if inflation were to rise to 5%, you would earn a negative real return
Theories addressing the negative correlation between inflation and stocks also argue that as equity prices are determined by the market’s estimate of a stock’s value, the lowered demand could possibly be a by-product of market participants’ equity valuation methods.
To understand this better, it’s important to touch on a widely used valuation technique appearing throughout the world of finance – discounting expected future cash flows to their respective present values.
The ‘present value’ of a future cash flow is the best estimate of what the future cash flow is worth in today’s money. In its most basic form, the present value formula is as follows:
PV = C / (1 + i)n
- PV = present value
- C = future cash flow amount
- i = interest rate (frequently called the ‘discount rate’)
- n = number of times the interest rate is to be compounded (eg an annualised interest rate is compounded five times if the cash flow is to be paid five years in the future)
The present value equals the future cash flow ‘C’ divided by an appropriate interest rate, (1 + i)n. The interest rate is often referred to as the ‘discount rate’.
A cash flow of £100 one year from now, at a discount rate of 5%, equals a present value of about £95.24. This is the important takeaway – the larger the discount rate, the smaller the present value. The present value of a cash flow of £100 five years from now, at 5%, is about £78.35 – the further into the future the flow, the lower the present value.
The question of the correct discount rate is of vital importance, and it’s here that inflation comes into the picture. If the inflation rate is used as an input in determining the discount rate, then a higher inflation rate will cause a higher discount rate.
For example, consider a stock that pays stable dividends at predictable and regular intervals. In this case, the value of the stock could be reduced to the sum of all the future dividend payments discounted to their present value. This reasoning is the basis of the dividend discount model (DDM).
When using the DDM, the higher inflation-adjusted discount rate acts to diminish the present value of each expected future dividend more than it would have before inflation. This, in turn, lowers the current price of the stock.
What are the stocks to watch when inflation is higher?
Value stocks have outperformed growth and income stocks in the short term during periods of high inflation. However, your response to an increased rate of inflation depends on whether you are taking a long or short-term view.
As a long-term investor, you could hedge against inflation and protect the value of your stored wealth by allowing your portfolio to pass increased costs on to consumers over time. For traders taking a short-term view, there is evidence to suggest that higher inflation also tends to lead to increased stock market volatility, creating opportunities for either buying or short-selling stocks.
The performance of value stocks during high inflation
Research suggests that value stocks are preferred by investors when inflation is high. Value stocks are shares that have a higher intrinsic value than their current trading price. They are frequently shares of mature, well-established companies with strong current free cash flows that may diminish over time.
During periods of high inflation, shares associated with larger current cash flows are more valuable than growth stocks that promise more distant returns. This could be due to the effect of compounding the discount rate in the present value formula.
When valuing equity in terms of discounting future cash flows, sizeable current cash flows will be less diminished than cash flows of comparable amounts further down the road. For example, £100 in one year discounted at 5% is worth £95.24 today, but the same flow in five years is only worth £78.35.
The performance of growth stocks during high inflation
Research indicates that growth stocks drop in price during high inflation. Growth stocks are shares that, while not showing strong current free cash flows or dividend pay-outs, demonstrate the potential to outperform the market in the future.
They are long-term investments, and worthwhile returns could only be expected after they have had a chance to mature and consistently produce better-than-average results.
When discounting growth stocks to a present value, the fact that the expected cash flows are still some time ahead means that the compounded discount rate will adversely impact the current share price.
The performance of income stocks during high inflation
Because income stocks pay regular and stable dividends, which may not keep up with inflation in the short run, their price will decline until the dividends rise to meet inflation.
International companies might also experience falling share prices when inflation increases: if a company raises prices too much, it runs the risk of becoming uncompetitive if foreign players operating in the same market are able to keep prices constant.
What does lower inflation mean for stocks?
As lower inflation is associated with lower interest rates and increased spending, the demand for shares grows as companies show strong revenues – this results in share price appreciation. Lower inflation is also good news for stocks with lower, but reliable, dividend pay-outs. That’s because the more modest the rate of inflation, the higher the real interest earned per payment.
For example, if the dividend is 5% and inflation is 3%, then the real interest is 2%. But, if inflation is 1%, then the real interest is 4%. The same goes for stocks with higher amounts of risk – both could experience an increase in demand, resulting in higher prices.
Lower inflation, interest and the business cycle
A significant feature of inflation policy is an increase in the short-term interest rate (sometimes referred to as the ‘tightening of monetary policy’). The higher cost of borrowing results in less investment spending by businesses and households, and those with disposable income prefer to hold interest-earning assets rather than depreciating money.
Real economic output slows, but so does inflation – if the monetary authority has acted correctly and is judged by the public to be trustworthy and effective.
Conversely, when inflation is low, interest rates may also drop – acting as an incentive to spend on investment. As can be seen in the above graph, in the business cycle, growth is intimately linked with both a lower interest rate and lower inflation.
The implication is relatively straightforward: when consumers and businesses spend, general economic growth should result, on the whole, in solid returns on equity, whether through dividends or share price appreciation.
Lower inflation and bonds
Lower inflation is also positive news for bonds. Inflation dampens the attractiveness of bond coupon payments, which results in investors expecting a higher yield to maturity. This increases the debt burden of those issuing bonds, which curbs debt-financed investment spending.
To clarify the above, coupon payments are the cash flows paid by the bond issuer to the bond holder at agreed times. As bonds are bought and sold on open markets, their prices can fluctuate depending on a variety of factors, including supply and demand.
The yield to maturity is the interest rate that equates the market price of the bond with the present value of its future coupon payments. The lower the price of a bond, the higher the bond’s yield to maturity for a given coupon payment. A high yield to maturity represents a high cost of debt to the bond issuer. Because companies finance investment through debt, a high cost of borrowing will lower the supply of new bonds to the market.
During low inflation, the decrease of inflation risk, from the bond buyer’s point of view, means that they are willing to pay a higher price to secure the future cash flows from the bond. The relationship between stocks and bonds is close knit, and the two often compete fiercely for investor funds.
How to hedge against inflation
As inflation erodes the wealth stored in each unit of money, hedging against inflation is the attempt to move wealth into assets that’ll resist depreciation or, in the best case scenario, actually appreciate at a higher rate than inflation.
When looking to hedge, there are a few options to consider:
- A well-diversified stock portfolio can act as a hedge in the long run if companies are able to adjust to higher input costs by raising their own prices or by switching to alternative inputs. Should this occur, revenues and free cash flows will rise (ensuring that real income is re-established), as will dividends. With inflation-adjusted flows and dividends back to normal real levels, share prices could appreciate to reflect the higher valuation
- Commodities are a traditional inflation hedge, and gold is often used as a safe-haven for wealth during inflationary periods. However, several factors have to be considered before assuming commodities will outperform other possible assets. A good way to gain exposure to the commodities markets is through exchange traded funds (ETFs) that comprise of a basket of different stocks
- Real estate investment trusts (REITs) are a possible hedge option as real estate prices and rental rates are highly responsive to inflation. Analysts show that returns on real estate have consistently proven to be resilient to surges in consumer price levels. In fact, real estate returns have been similar to stock market returns, but with lower volatility and less cyclicality. A REIT is a pool of real estate assets that distributes dividends earned from income-producing property to trust shareholders
- In the short term, short-selling stock can act as a hedge if market demand for those stocks falls while inflation rises. Growth stocks and income stocks may suffer a diminished price owing to a decreased present value of dividends and future free cash flows
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Inflation and the stock market summed up
- Inflation is the rate at which the value or wealth that money stores is eroded over time. Put differently, it is the rate at which money loses purchasing power. An increased rate of inflation means a higher overall price level and lowered levels of ‘real’ income until wages adjust upwards, too
- The relationship between inflation and stock prices is complex and each stock should be evaluated on its individual merits
- In the long run, companies pass increased input costs on to consumers. Given enough time, this means that real revenues and profit rates may return to normal levels, making a diversified non-leveraged portfolio a possible hedge against inflation over the long term
- In the short run, experts suggest a frequent inverse correlation exists between inflation and share prices – as inflation rates rise in the short term, share prices fall and vice versa. This could owe to a variety of factors, including stock valuation techniques that use the inflation rate to increase the nominal rate of required return (the discount rate) to assess share prices
- Value stocks tend to outperform growth and income stocks during periods of higher inflation
- Inflation hedges are assets that outperform the market during periods of high inflation, which helps to preserve wealth. No hedge is ever perfect, but options include a long-term position with a diverse stock portfolio, commodities, real estate, or short-selling growth and income stocks
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
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