How inflation impacts your stock returns
Investors will have recently noted with interest the increased volatility in the stock market, with this being triggered by a myriad of macroeconomic and geopolitical factors.
However, rampant inflation is perhaps weighing heaviest on the stock market at present, peaking at a 30-year high of 6.2% in the UK in February before increasing once again to 7% in March.
In the US, inflation reached a 40-year high of 8.5% in March, as the purchasing power of the world’s major currencies declines and consumer confidence continues to plummet.
Over time, this will impact business’s earnings and share performance, impacting directly on investor returns. We’ll explore this further in the article below, while asking what you should expect as 2022 progresses.
What is inflation?
In simple terms, inflation refers to a rise in the price of goods and services, with this natural economic occurrence considered to be a positive and capable of stimulating growth in small doses.
For example, nominal rates of inflation encourage customers to buy goods and services sooner and stimulate spending, boosting economic growth and sentiment in the process.
This is why central banks such as the Bank of England and the Federal Reserve (in the US) set inflation cap targets of 2%, in order to strike a desirable balance between healthy price growth and an affordable cost of living for households.
The landscape changes with the type of rising inflation we have now (which in the UK is more than three-times higher than the central bank’s target), with households the first to be hit. More specifically, they see a reduction in the power of the pound in their pockets, diminishing their discretionary spending and the amount subsequently reinvested into the economy.
It’s from here that businesses begin to feel the pinch, especially in relation to reduced earnings, squeezed margins (especially as the central bank increases the base rate of combat inflation) and lower market valuations.
The impact of inflation on your stock returns
As you can imagine, the wider macroeconomic consequences of inflation and the direct impact on household spending causes huge volatility in the stock market.
This is why indices such as the S&P 500 and the Nasdaq have depreciated by 11% and 17% respectively since the beginning of 2022, while further peaks and troughs are largely expected through the remainder of the year.
According to various studies conducted through the years, the fact that higher inflation tends to correlate with lower equity valuations is an observable truth. This is particularly evident in emerging economies, where countries have tended to suffer their worst returns during periods of high inflation or hyperinflation.
But what does this mean for investors and your stock returns? Well, the market is likely to be particularly volatile in the near-term, with the reduced purchasing power of the pound and similar currencies weighing heavily on consumer spending in an absence of real wage growth.
This is already causing customers to feel the pinch, with businesses likely to see reduced spending and demand for goods (especially in some sectors) during the second quarter.
Another key issue in the short-term is that the Central Bank is looking to combat inflation directly by hiking the base interest rate. This has increased from 0.1% to 0.75% in just four months between December and March, causing the cost of borrowing to soar and squeezing company margins at both ends.
So, company earnings are likely to take a significant hit through the second quarter at least, directly impacting share prices and the value of stocks in the process.
The worst affected stocks will be growth options, with high-dividend assets of this type typically hammered in the same manner as fixed-rate bonds during periods of increased and heightened inflation.
Conversely, value stocks tend to outperform the market average during periods of high and sustained inflation. The reason for this is simple; as ‘value’ stocks are categorised as short duration assets which enable investors to recoup their capital sooner as opposed to later.
Given that the purchasing power of money is worth more in real-time within a high-inflation environment, value stocks are far more attractive in a world where the cost of living is continuing to rise across the board.
Of course, there are some markets that also outperform others during high inflation. As a general rule, entities that can pass their own rising costs directly onto customers without impacting demand (such as those in the consumer staples sector) tend to perform better than others from the perspective of returns.
Additionally, studies have shown that real estate (which is commonly used as a hedge against inflation), healthcare and energy sectors also offer increased value during periods of inflation.
This has definitely been borne out in 2022 so far, with the three best performing equities of the year so far all based in the energy services sector.
The bottom line
As we can see, sustained periods of rising inflation (above low-level increases and central bank targets) tend to have a negative market on the demand for goods and services and company earnings over time.
This, in turn, adversely affects company valuations and share prices, creating a challenge for traders who are heavily invested in certain markets or buy-and-hold investments.
While returns and the value of your profits can be undermined by inflation, however, some types of stock perform better than others. Value stocks certainly offer greater appeal in the current climate, especially with the current rate of inflation unlikely to be sustained indefinitely.
Consumer staples and firms in the energy sector are also known to perform better than others during periods of rampant inflation, and 2022 has certainly seen oil and gas service providers outperform the market average.
Another way in which stock traders can beat inflation is by investing in index funds. These entities not only minimise your exposure by enabling you to target a broad range of grouped equities, but they also have a habit of keeping pace with and even beating inflation.
The key is to target strong index funds in the type of sector that we referenced earlier (especially real estate), which have the capacity to record sustained growth despite the short-term macroeconomic imbalance.
Index funds also create instant diversification within your portfolio, while enabling you to go short or long depending on the course that the markets take.
So, while inflation can have a negative impact on your stock returns over time, there are still ways in which you can minimise losses and thrive even as the cost of living soars.