1/19/2021 Inflation's Impact on Stock Returns

MARKETS STOCK MARKETS

Inflation's Impact on Stock Returns

By KRISTINA ZUCCHI | Updated Oct 2, 2020

TABLE OF CONTENTS
Inflation and the Value of $1 Inflation and Stock Returns
Growth vs. Value Stocks Income Stocks and Inflation
The Bottom Line
EXPAND +

Investors, the Federal Reserve, and businesses continuously monitor and worry about the level
of inflation. [1] Inflation—the rise in the price of goods and services—reduces the purchasing
power each unit of currency can buy. Rising inflation has an insidious effect: input prices are
higher, consumers can purchase fewer goods, revenues, and profits decline, and the economy
slows for a time until a measure of economic equilibrium is reached.

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KEY TAKEAWAYS
Rising inflation has an insidious effect: input prices are higher, consumers can purchase
fewer goods, revenues, and profits decline, and the economy slows for a time until a
measure of economic equilibrium is reached.
Value stocks perform better in high inflation periods and growth stocks perform better
during low inflation.
When inflation is on the upswing, income-oriented or high-dividend-paying stock
prices generally decline.
Stocks overall do seem to be more volatile during highly inflationary periods.
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Inflation and the Value of $1

The chart below gives a sense of how dramatically inflation can reduce purchasing power:

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Consumer Price Index for All Urban Consumers

Purchasing Power of the Consumer Dollar in U.S. City Average

$400.00

300.00

200.00

100.00

0.00
Jan 1950 Jan 1960 Jan 1970 Jan 1980 Jan 1990 Jan 2000 Jan 20

Source: St. Louis Federal Reserve

Get the data • Add this chart to your site

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This negative impact of rising inflation keeps the Fed diligent and focused on detecting early
warning signs to anticipate any unexpected rise in inflation. [2] The sudden increase in inflation
is generally considered the most painful, as it takes companies several quarters to be able to
pass along higher input costs to consumers. [3] Likewise, consumers feel the unexpected “pinch”
when goods and services cost more. However, businesses and consumers eventually become
acclimated to the new pricing environment. These consumers become less likely to hold cash
because the value over time decreases with inflation.

High inflation can be good, as it can stimulate some job growth. [4] [5] [6]
But high inflation can
also impact corporate profits through higher input costs. [7] This causes corporations to worry
about the future and stop hiring, reducing the standard of living of individuals, especially those
on fixed incomes.

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For investors, all this can be confusing, since inflation appears to impact the economy and stock
prices, but not at the same rate. Because there is no one good answer, individual investors must
sift through the confusion to make wise decisions on how to invest in periods of inflation.
Different groups of stocks seem to perform better during periods of high inflation.

Inflation and Stock Market Returns

Examining historical returns data during periods of high and low inflation can provide some
clarity for investors. Numerous studies have looked at the impact of inflation on stock returns.
Unfortunately, these studies have produced conflicting results when several factors are taken
into account, namely geography and time period. Most studies conclude that expected inflation
can either positively or negatively impact stocks, depending on the investor's ability to hedge
and the government’s monetary policy. [8] [9]

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Unexpected inflation showed more conclusive findings, most notably being a strong positive
correlation to stock returns during economic contractions, demonstrating that the timing of the
economic cycle is particularly important for investors gauging the impact on stock returns. [10]
This correlation is also thought to stem from the fact that unexpected inflation contains new
information about future prices. Similarly, greater volatility of stock movements was correlated
with higher inflation rates.

The data has proven this in emerging countries, where the volatility of stocks is greater than in
developed markets. [11] Since the 1930s, the research suggests that almost every country
suffered its worst real returns during high inflation periods. Real returns are actual returns
minus inflation. When examining S&P 500 returns by decade and adjusting for inflation, the
results show the highest real returns occur when inflation is 2% to 3%. [12] [13] Inflation greater
than or less than this range tends to signal a U.S. macroeconomic environment with larger
issues that have varying impacts on stocks. [14] Perhaps more important than the actual returns
are the volatility of returns inflation causes and knowing how to invest in that environment.

Growth vs. Value Stock Performance and Inflation

Stocks are often broken down into subcategories of value and growth. Value stocks have strong
current cash flows that will slow over time, while growth stocks have little or no cash flow today,
but are expected to gradually increase over time. [15]

Therefore, when valuing stocks using the discounted cash flow method, in times of rising
interest rates, growth stocks are negatively impacted far more than value stocks. [16] [17] Since
interest rates are usually increased to combat high inflation, the corollary is that in times of high
inflation, growth stocks will be more negatively impacted. This suggests a positive correlation
between inflation and the return on value stocks and a negative one for growth stocks.

Interestingly, the rate of change in inflation does not impact the returns of value versus growth
stocks as much as the absolute level. The thought is that investors may overshoot their future
growth expectations and upwardly misprice growth stocks. In other words, investors fail to
recognize when growth stocks become value stocks, and the downward impact on growth
stocks is harsh. [18]

Income-Generating Stocks and Inflation

When inflation increases, purchasing power declines, and each dollar can buy fewer goods and
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When inflation increases, purchasing power declines, and each dollar can buy fewer goods and
services. For investors interested in income-generating stocks, or stocks that pay dividends, the

impact of high inflation makes these stocks less attractive than during low inflation, since
dividends tend to not keep up with inflation levels. [19]  In addition to lowering purchasing
power, the taxation on dividends causes a double-negative effect. [20]  Despite not keeping up
with inflation and taxation levels, dividend-yielding stocks do provide a partial hedge against
inflation.

Similar to the way interest rates impact the price of bonds—when rates rise, bond prices fall—
dividend-paying stocks are affected by inflation: When inflation is on the upswing, income stock
prices generally decline. So owning dividend-paying stocks in times of increasing inflation
usually means the stock prices will decrease. But investors looking to take positions in dividend-
yielding stocks are allowed to buy them cheap when inflation is rising, providing attractive entry
points.
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The Bottom Line

Investors try to anticipate the factors that impact portfolio performance and make decisions
based on their expectations. Inflation is one of those factors that affect a portfolio. In theory,
stocks should provide some hedge against inflation, because a company’s revenues and profits
should grow at the same rate as inflation, after a period of adjustment. However, inflation’s
varying impact on stocks confuses the decision to trade positions already held or to take new
positions. In the U.S. market, the historical proof is noisy, but it does show a correlation to high
inflation and lower returns for the overall market in most periods.

When stocks are divided into growth and value categories, the evidence is clearer that value
stocks perform better in high inflation periods, and growth stocks perform better during low
inflation. One way investors can predict expected inflation is to analyze the commodity markets,
although the tendency is to think that if commodity prices are rising, stocks should rise since
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companies “produce” commodities. However, high commodity prices often squeeze profits,
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which in turn reduces stock returns. Therefore, following the commodity market may provide
CONOZCA
insight A SU
into future NUEVO
inflation rates. [21]
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Related Terms
Inflation
Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of
goods and services in an economy. more

Return
In finance, a return is the profit or loss derived from investing or saving. more

What Is Preservation of Capital?

Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital
and prevent loss in a portfolio. more

Gross Domestic Product (GDP)

Gross domestic product (GDP) is the monetary value of all finished goods and services made within a
country during a specific period. more

Inflation Trade Definition

An inflation trade is an investing scheme or trading method that seeks to profit from rising price levels
influenced by inflation. more

Indexation Definition
Indexation is a method of linking the price or value of an asset to a price or price index of some type to
adjust for inflation. more

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