As prices of goods and services rise, the purchasing power of consumers decreases. This leads to slower economic growth and reduced profits for companies, which in turn can lead to a drop in their stock prices.
When investors anticipate rising inflation, they may reevaluate their portfolios to reduce exposure to stocks. This can also lead to a decline in stock prices.
In this article, we explore how rising inflation can affect the stock market and what investors should be aware of.
What is Inflation?
Inflation is the rate at which prices for goods and services increase over time.
It is the general increase in prices in an economy over a period of time which then lowers the purchasing power of each unit of money.
Inflation is measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI) which tracks the prices of goods and services.
Central banks usually use monetary policies to try to control inflation and keep it at a healthy level.
Nigeria has been facing high inflation for some time now. This has been a result of factors such as currency devaluation, economic mismanagement and insecurity, to mention a few.
As of November 2022, the inflation rate in Nigeria was at an all-time high of 21.47%, compared to the 15.92% recorded in November 2021.
How Inflation Affects The Stock Market
Here are 5 ways inflation affects the stock market:
1. Reduced corporate profits
Corporate profit margins may suffer due to increasing costs and unstable revenue growth. Rising inflation can lead to increased costs for companies, reduced profits and a decline in stock prices.
2. Interest rates
Excessive inflation raises questions about interest rates. When inflation is high, central banks often raise interest rates to try to slow it down. This makes borrowing more expensive which can negatively impact companies and reduce demand for stocks.
3. Currency devaluation
Inflation can also lead to the devaluation of a country’s currency. This hurts the stock market by making exports more expensive and reducing the value of investments held in such currency.
4. Purchasing power
As earlier mentioned, inflation erodes people’s purchasing power—and this leads to reduced consumer spending and lower stock prices.
5. Uncertainty
High inflation can create uncertainty in the market, causing investors to become more risk-averse. Investors begin to adjust their portfolios to reduce exposure to stocks, leading to a decrease in stock prices.
This is because it is harder for investors to predict the future earnings of companies and the future value of their investments when inflation is high.
Growth and Value Stocks
Growth stocks and value stocks are two types of stocks that can be found in the stock market.
Growth stocks are stocks of companies with strong and increasing customer demand. These companies are expected to grow at a faster rate than the market and they reinvest earnings back into the business. However, they are generally more volatile and more sensitive to economic cycles.
Value stocks are stocks of traditional, well-known companies that have already become market leaders, and have strong fundamentals and a history of paying dividends. They are generally considered to be less risky than growth stocks and tend to perform well in a bear market.
In inflation, growth stocks typically exhibit a greater sensitivity to changes in interest rates and suffer more impact than value stocks.
Why is Inflation Good for Value Stocks?
Overall, stocks suffer from inflation. However, because value stocks’ prices are yet to keep up with growth stocks, they tend to handle inflation better.
Here are a few ways to look at how inflation works better with value stocks:
Dividends: As the cost of goods and services increases, the dividends from value stocks can help offset the negative effects of low purchasing power. Value stocks often always pay dividends.
Low valuation: Value stocks are often considered to be undervalued by the market, meaning that they are trading at a lower price relative to their earnings or assets. In an inflationary environment, the value of these earnings and assets can increase, which can lead to a higher stock price.
Economic cycles: Generally, value stocks tend to perform better in a bear market or recession, which is often caused by high inflation. As the economy slows down and the growth stocks’ earnings decrease, value stocks tend to hold their ground.
Learn more about What to Invest in During a Recession.
Valuable tips for investing in the stock market during inflation
Invest in assets that have performed well historically. But, note that history is not always a guarantee of future performance.
- Diversify your holdings. Guard yourself against inflation. Don’t overly concentrate on one asset class.
- Consider international investments. Investing in foreign companies and markets can also help diversify your portfolio and provide exposure to different economic conditions.
- Invest in commodities. Examples of commodities are raw materials, natural resources needed for production, gold and other precious metals. As demand grows, prices rise, and the cost of manufacturing is to meet that demand. During inflationary times, commodities are often viewed as safe-haven investments.
- Invest in inflation-protected securities. Treasury Inflation-Protected Securities (TIPS) and other inflation-protected investments can protect your portfolio from inflation.
- Focus more on value investing because it is an investment style that tends to do well. Look for companies with strong fundamentals. Companies with strong financials and a history of steady growth are more likely to perform well during inflation. Value stocks frequently have excellent cash flow and a low price-to-earnings ratio. A wise strategy could be to combine value investing with inflation-protected securities.
- Keep a long-term perspective. Inflation can be volatile in the short term, but over the long term, the stock market has historically performed well. It’s important not to make hasty decisions based on short-term market fluctuations.
Bottom Line
Inflation can have a huge impact on the stock market—from purchasing power, value of investments, and stock prices to the overall health of the economy. However, by diversifying your portfolio, investing in inflation-protected securities, looking for companies with strong fundamentals, and keeping a long-term perspective, investors can mitigate the effects of inflation and potentially even benefit from it.
As always, it’s recommended to consult a financial advisor before making any investment decisions.
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