Inflation affects all of the world’s economies. Every government in the world operates on fiat currency. This currency retains value based on the confidence the public holds in such money. Every fiat currency sees some inflation. Developed world currencies such as the United States dollar see only a small amount. Other currencies, such as the Venezuelan bolivar, can lose significant amounts of value by the minute. Still, by understanding its effects, the stock market can serve as an ally both in mitigating its costs and building wealth during inflationary times.
Inflation defines the rate at which the U.S. dollar or any other currency loses value. For example, if one lives on $100,000 per year in an environment of 2% per year inflation, that person will need to earn $102,000 next year to maintain the same standard of living. Americans have dealt with this on a consistent basis since World War II — and intermittently before.
The same effect would apply to the stock market. If the Dow Jones Industrial Average stands at 25,000, the Dow must rise to 25,500 to maintain its current value with inflation at 2%.
Effects of Low and High Inflation
The effects are more alarming in an environment of hyperinflation. Economists believe Venezuela will see a 1,000,000% inflation rate. If the 25,000 Dow were to be measured in Venezuelan bolivars, the index would have to rise to 250 million merely to maintain the same value!
While 1,000,000% inflation destroys confidence in an economy, lower rates can have some positive effects. It places more cash into the economy, which can stimulate spending or job creation. It also affects debtors. In a 2% inflation environment, a $200,000 mortgage falls to about $196,000 in real terms within one year, even if the lender makes no principal payments.
However, these benefits come at a price. Americans spend an average of 18 years in retirement. At a 2% rate, that 25,000 Dow has to grow to 35,706 to maintain its value during this time. However, long-term investors cannot count on the rate of increase staying this low. During the 1970s, inflation exceeded 10% in some years. If we ran the same calculation at a 10% rate, the Dow level needed to maintain real value would need to rise 139,000! Thus, the cost of today’s $100,000 lifestyle increases to $556,000 in 18 years under such conditions. Whether the rate remains low or goes higher, retirees must consider inflation when calculating their needs.
How Inflation Affects the Market
Investors also need to understand that inflation spikes may not immediately show up in the stock market. The Dow 30 Index rose as high as 990 in 1966. For many reasons, inflation saw higher levels during this time. As a result, the Dow traded in a range of 600 to 990 until 1982, when the index finally rose above 1,000. Thanks to dividends, the S&P 500 still grew at a 6.8% annual rate during this time. However, with average inflation at nearly the same level during the period, inflation wiped out any real returns. The government managed to keep inflation in the 2-5% range after 1982, and only then did the stock market see real gains.
Still, I think this serves as a lesson to stay in the market in times of low or high inflation. While the 1966-82 period proved challenging, S&P 500 investors at least protected their wealth during these tough times.
Moreover, options exist within the market for retirees. Dividend aristocrats, stocks which have increased dividends annually for at least 25 years, can position retirees to protect against inflation. Aristocrats such as AT&T (NYSE:T) or Johnson & Johnson (NYSE:JNJ) face tremendous pressure to maintain dividend increase streaks. Such increases can help a retiree keep pace with or beat inflation. Retirees who do not want to risk their savings in individual stocks can gain this benefit through a dividend-oriented ETF such as the SPDR S&P Global Dividend ETF (NYSEARCA:WDIV) or the Vanguard High Dividend Yield ETF (NYSEARCA:VYM). These equities should bring growing dividends and hopefully, price growth over time.
Inflation left by itself harms savers. However, with the help of the stock market, investors can protect and grow their wealth despite its effects. This event represents the rate at which currencies lose their value. Even if one lives in a country with a stable currency, the phenomenon can have devastating effects over time.
However, history has proven that through dividends, the stock market can help people maintain their wealth, even when indexes struggle to move higher. Moreover, many stocks face pressure to sustain dividend increases. This need can help protect wealth from these purchasing power reductions.
All of us feel it, but by understanding the effects and how the stock market can both preserve and increase wealth, investors can live with and benefit from this phenomenon.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.