Inflation is an economic phenomenon that affects all aspects of the economy, including consumer spending, business investment, the rate of unemployment and interest rates. In its simplest definition, inflation is a sustained rise in overall price levels. It can be argued that low inflation is related to economic growth, while high inflation is dangerous and can not only signal an overheated economy, but can derail economic growth and even increase the risk of a recession in the broader economy.
What does inflation do to the stock market? The answer is complex but can be made easier depending on whether there is a period of moderate to low inflation or a period of very high inflation, like now in the U.S.
How Does Low Inflation Affect the Stock Market?
The stock market is a continuous mechanism for evaluating current economic conditions and discounting future conditions. The ideal scenario for the stock market is to have a sustained period of low-to-moderate inflation, 1%-3%.
This is good because it means the economy is not overheated, there is demand for goods and services that is healthy, the prices of goods and services tend to be rather stable and the eroding value of each dollar is acceptable.
Inflation erodes the value of income, savings, investments and money overall. When inflation is high, as it is today in the U.S., the consumers lose a larger portion of their buying power. They need more money to buy the same amount of goods as compared to the past.
For example, high oil prices have made transportation costs increase significantly. In a period of high inflation, companies must pay more for raw materials, moving goods and running their factories. Of course, the companies can increase their prices of goods and transfer some or all of the impact of inflation to the consumers. Still higher prices are not treated favorably by consumers.
High inflation, in a nutshell, causes a lot of uncertainty. As consumers must make more careful decisions on their spending habits, retail sales could slow down, and in the U.S. market, a slowdown in retail spending is very bad news. It can lead to lower economic growth.
Lower economic growth will be negative news for investors, and chances are the stock market will be weak when inflation is too high. This explains the stock market performance in 2022.
Do Stocks Go Up or Down During Inflation?
When inflation is low, the cost of money is also low, and growth stocks in theory should perform better than value stocks.
On the contrary, when inflation is high, value stocks should perform better compared to growth stocks. But valuation concerns in a period of high inflation push the stock market lower.
The bad news is that high inflation takes time to return to a normal range. Inflation is near 8% in the U.S., the normal range of inflation is 2%-3%, so the Federal Reserve will have to increase the key fund rate to try to tame it. Using a higher risk-free rate in a discounted cash flow model to value stocks, means that the valuation of equities is driven lower. Lower valuations mean that there must be a gradual rebalance between observed stock prices and their intrinsic worth. The downside is the most logical path for the stock market.
Higher inflation increases the cost of money and capital. Companies that have a high level of debt are worse off in an environment of rising interest rates. This explains why high-growth stocks, companies that have debt, suffer when inflation is high and interest rates are rising.
High Inflation Makes the Stock Market More Volatile
The stock market is already volatile in 2022 and it should get even more volatile as higher interest rates come to pass. High inflation can make nominal returns negative. For example, assume you have a return of 5%-6% in your stock portfolio. When you consider inflation is at 8%, the real return, where you subtract nominal return from inflation, is negative. This makes stock picking in a high-inflation era more important than when there is low inflation present.
The chance of a recession — two consecutive periods of negative economic growth — is likely when inflation is very high. This may turn investor sentiment to risk-off mode, as it should, and therefore cause a shift of investing style. I would argue that high-dividend stocks are a safe choice when inflation is high, as they compensate with generous passive income for the loss of purchasing power.
In the end, high inflation is not only bad news for the stock market but is an unsustainable economic condition that can derail the growth and strength of the economy. To the extent that businesses do not pass the inflation to consumers, this means lower profitability, and therefore high odds of lower stock prices.
So in sum, high inflation spells a lot of trouble for the economy and the stock market.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.