Inflation and Its Impact on the Stock Market

Inflation is a key concept that everyone has learned in their introductory economics courses. Most of us also hear about inflation frequently in the news. So what is inflation? How do macroeconomic indicators like inflation impact the stock market?

Inflation refers to the rising price levels and it is usually measured using the Consumer Price Index (CPI). Currently, in the U.S., the average annual inflation rate has been around three percent for the past twenty years. This means that the real value of the same amount of money has decreased by 3 percent each year, if not invested. Inflation has been rising in the U.S.; reaching around 5 percent in recent months. This rise is mostly driven by rising food prices, supply shortages,  and higher energy prices (Domm, 2021). As the economy recovers from the impact of the pandemic, the Fed recently announced that it will “begin tapering its asset purchases” (Levy, 2021). The central bankers claim that the higher prices are likely "temporary" and the inflation rate would decrease once the supply chain shortages are resolved (Levy, 2021). However, many investors don’t think inflation is transitory. Investors are concerned if inflation stays high, the Fed would have to raise interest rates earlier than expected (Mozée, 2021).

Investors are worried about the potential impact of rising prices on their investments. Stock investors need to factor in inflation when calculating expected returns. Higher inflation makes real return lower when an investment has the same nominal return. Inflation also makes inventories and labor more expensive and could hurt companies’ profitability. Unexpected inflation eats up investors’ returns and leads to lower real returns. Therefore, investors are constantly trying to forecast future inflation rates so that they would know their expected real return. Higher interest rates also reduce the present value of their investments. Therefore, the market sometimes reacts even before the Fed signals its potential actions.

Inflation affects the stocks of various companies differently. When inflation is high, “sectors such as Energy, Real Estate, Health Care, Utilities, and Consumer Staples historically have outperformed on average. Others such as Consumer Discretionary, Industrials, Materials and Financials have struggled in general” (Kastner, 2021). Due to the impact of the Covid -19 pandemic, the Information Technology sector will likely remain strong, despite weaker historical performance in the high inflation environment. The IT sector has become less cyclical due to the high demand for IT equipment and consumer electronics during the pandemic (Kastner, 2021). Even within the same industry, inflation asymmetrically affects different types of companies. “Growth stocks tend to underperform when inflation is higher” because “growth stocks have much of their earnings in the future” (Pisani, 2021). Growth stocks tend to have low cash flow today but are expected to grow dramatically in the future, while value stocks have steadier profit levels. When investors evaluate stocks using the discounted cash flow method (DCF), the value of the company is based on the present value of projected future profits. The central bank tends to raise the interest rate to combat inflation, which leads to a higher discount rate in the DCF. Growth stocks are more negatively impacted by inflation than value stocks since a larger portion of their cash flow is in the future (Pisani, 2021). When inflation and, by extension, interest rates are higher, the current value of a future stream of earnings is significantly reduced.

In conclusion, macroeconomic indicators like inflation are very important to investors. Investors closely monitor the Fed’s announcements and actions to forecast inflation. Inflation and interest rates have different effects on companies in different industries. The impact of inflation on stocks is highly uncertain. 

Edited by Stephen Adams

Works Cited

Levy, Mickey. “Fed Complacency Feeds Inflation.” WSJ, 31 Oct. 2021, www.wsj.com/articles/fed-complacency-feeds-inflation-unemployment-supply-asset-11635705390.

Pisani, Bob. “Here’s Why Stock Investors Are Watching Inflation so Closely.” CNBC, 14 May 2021, www.cnbc.com/2021/05/13/heres-why-stock-investors-are-watching-inflation-so-closely.html.

Domm, Patti. “Stocks Could Soar to New Heights in Week Ahead — Even Though Inflation Data May Come in Hot.” CNBC, 5 Nov. 2021, www.cnbc.com/2021/11/05/stocks-could-soar-to-new-heights-in-week-ahead-even-though-inflaton-data-may-come-in-hot.html?&qsearchterm=inflation.

Mozée, Carla. “The S&P 500 Will Jump 12% to 5,000 next Year as Corporate Profits Fuel Stock-Market Gains, UBS Says.” Markets.Businessinsider.Com, 24 Aug. 2021, https://markets.businessinsider.com/news/stocks/stock-market-outlook-sp-500-stocks-earnings-economy-fed-2021-8

Kastner, David. “Schwab Sector Views: Financials—Opportunity or End of the Run?” Schwab Brokerage, 2021, www.schwab.com/resource-center/insights/content/sector-views.