While the inflation rate is lower than in mid-2022, the rate is still pretty high overall. Since inflation has been an ongoing issue, many people are increasingly wondering, “How does inflation affect stocks?” Ultimately, inflation can impact the stock market in many ways. Here are five things you need to know about how inflation impacts stocks.
1. Broad Inflation Impacts Nearly Any Stock
While most reports about inflation focus on a single figure based on average price changes of products and services listed in the Consumer Price Index (CPI), it doesn’t show the disparities between the various product and service categories. Some consumer categories may see double-digit inflation, while others may see minor changes or even declines.
The trick is that broad inflation has an impact on practically every stock. When consumer prices rise in many core categories – such as groceries, utilities, and gasoline – it significantly impacts household budgets. This can lead to a widescale spending decline, potentially affecting the bottom line of any consumer-oriented business, particularly those deemed non-essential. Essentially, those companies are seeing falling revenues, and when revenues decline, stock prices usually suffer.
However, even companies selling essential consumer goods and services aren’t shielded from stock market declines. Rising prices can mean consumers scale back, looking for ways to save on essentials. Again, this can lead to diminishing revenue even if consumer prices rise, which drives stock prices down.
Additionally, all companies are seeing their costs rise. Inflation also impacts the price of materials they require for producing the products they sell. Since their costs are going up, profits can fall, which is something else that lowers the stock price.
2. Rising Inflation Reduces Access to Money
When inflation goes up, a common path for countering it is increasing interest rates in the Federal Reserve. While this doesn’t seem like it would impact stocks, it actually does. Higher interest rates – and the stricter borrowing requirements that come with it – limit businesses from getting credit. That can hinder various activities, including developing new products, expanding facilities, replacing aging equipment, and more.
As a result, companies can become relatively cash-strapped, preventing them from pursuing actions they would if funding were more accessible and affordable. In some cases, the ramification of waiting is lower stock prices.
3. Inflation Triggers Market Volatility
Market volatility often accompanies inflation. Along with issues like those above leading to quickly shifting prices, inflation also influences investor sentiment. Those with established portfolios may see the total value of their investments decline, causing them to make reactive investment choices. They may sell for fear of losing more value or might avoid investing more since they’re worried the investment will continue declining after purchase.
Investors with less income may also scale back from investing, particularly if they’re otherwise struggling to make ends meet when prices rise. Again, this is a change in broader investor behavior, and it can lead to more volatility.
Individuals getting close to retirement may also move their investments quickly during inflation. Often, it’s a means of preserving as much of their portfolio value as possible, which is more necessary if you plan on tapping those funds soon. They may also need to withdraw more than originally anticipated to cover their rising expenses, leading to more money withdrawing from the market than would otherwise.
4. Rising Interest Rates Make Stocks Less Appealing
During periods when interest rates are low, stocks end up more appealing. Often, that’s because getting returns anywhere near what the stock market offers through safer options like high-yield savings accounts or Treasury bonds isn’t possible. If growth is the goal, stocks seem like the only option.
When interest rates rise, returns on lower-risk options usually go up while stock market returns decline. As a result, transitioning funds to Treasury bonds or high-yield savings accounts could lead to more growth until the situation stabilizes, potentially negatively impacting the broader market.
5. Inflation Could Create Opportunities for Bargains in the Stock Market
One benefit of lower stock prices is that they could lead to opportunities for bargains in the stock market. Long-term investors could pick up shares below the price they’ve seen in the period leading up to the high inflation. Then, if the economy recovers, the values of those stocks usually rise, leading to potentially solid returns. This is especially the case if the stock’s price has declined due to changes in interest rates, and not to any change in their core business or dividend payout.
Ultimately, there is risk in using this approach. It isn’t clear how long inflation will remain an issue or how high-interest rates will go. Additionally, some companies may fail to weather the current storm, causing them to lose value and not recover. However, businesses with a history of stability, even during challenging times, are worth exploring. Make sure to research any investment thoroughly when volatility in the market and uncertain economic conditions are part of the equation. That ensures investors can find opportunities with risk levels they’re comfortable with, and that makes a difference.
Did the information above help you answer the question, “How does inflation affect stocks?” or is there something else you wanted to know? Do you have any points you’d like to share that could help others see how inflation impacts stocks? Share your thoughts in the comments below.
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Tamila McDonald is a U.S. Army veteran with 20 years of service, including five years as a military financial advisor. After retiring from the Army, she spent eight years as an AFCPE-certified personal financial advisor for wounded warriors and their families. Now she writes about personal finance and benefits programs for numerous financial websites.
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