The level of inflation is a very important factor that the
Federal Reserve, investors, and corporations always watch.
What is inflation?
Inflation is basically the increase in the price of goods
and services. As such, it minimizes the buying power of each currency.
Increasing inflation has a disastrous effect when input
prices are higher and there are fewer goods that consumers can buy. Consequently,
revenues and profits decline, and the economy slows down for a time.
Inflation and Stock Returns
Numerous studies have been conducted to study the effect of inflation
on stocks, taking into account the contribution of several other factors such
as geography and time period.
Most of these studies find out that expected inflation
either positively or negatively affect stocks. This largely depends on the
investor’s ability to hedge and the government’s monetary policy.
Unexpected Inflation
On the other hand, unexpected inflation sported more
conclusive findings. One of these is the strong positive correlation to stock
returns during economic contractions, showing that the timing of the economic
cycle is especially important for investors that measure the effect on stock
returns.
This correlation is also believed to come from the fact that
the unexpected inflation contains new information about future prices. In a
similar manner, greater volatility of stock movements was correlated with
higher inflation rates.
Growth vs. Value Stock Performance and Inflation
Stocks are usually divided into two sub-categories of value
and growth.
Value stocks have
strong current cash flows that will slow down over time. Meanwhile, growth stocks have little or no cash
flow at present, but will slowly increase over time.
Thus, when using the discounted cash flow method of stock
valuation, in times of rising interest rates, growth stocks are negatively
impacted far more than value stocks.
Since interest rates are typically increased to fight high inflation,
the result is that in times of high inflation, growth stocks will be more negatively
affected.
This indicates a positive correlation between inflation and
the return on value stocks while it’s a negative shot for growth stocks.
Income-giving stocks and Inflation
When inflation rises, the purchasing power declines, and
each dollar can buy fewer number of goods and services. For investors who are
interested in dividend-paying stocks, the effect of high inflation makes these
stocks less attractive than low inflation.
That’s because dividend usually do not keep up with
inflation levels. In spite of not keeping up with inflation and taxation levels,
dividend-yielding stocks do provide a partial hedge against inflation.
Similar to the way bonds are affected by interest rates,
when inflation rises income-paying stocks generally slump.
That means when you own income-generating stocks during high
inflation, stock prices usually decrease. However, investors looking to take
positions in dividend-paying stocks usually get the opportunity to buy them
cheap when inflation is rising, offering good entry points.
Conclusion
Investors usually try to anticipate the factors that affect their
portfolio’s performance and make decisions depending on their conjectures. Inflation
is one of those factors that greatly affect a portfolio.
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