How does inflation affect the stock market?
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This guide to inflation and the stock market explains the causes of inflation and how investors usually react to it. Learn about how different asset classes are affected and how you can create a portfolio that’s as inflation-resistant as possible.
What is inflation?
Inflation is a reduction in the purchasing power of the money in your pocket. It’s defined by a broad rise in the price of goods and services that results in an increase in the cost of living. In the UK it’s measured through the Consumer Price Index (CPI), which simply tracks the price of a basket of everyday household items over time and releases the data every month.
What causes inflation?
There are many factors that affect prices and periods of high inflation usually mean a few of them are acting in tandem. Below are the most common inflation causes, with a quick description of what they mean.
- Increase in the money supply. Central banks that print more money can cause a devaluation of a currency and reduce its purchasing power. When money is worth less, goods and services become relatively more expensive.
- Increase in production costs. The rise in costs of producing goods causes inflation because the price of goods goes up to match production costs.
- Surge in consumer demand. A sudden surge in overall consumer demand creates an economic situation where consumers are willing to pay higher prices for the existing supply of goods and services. Their willingness to pay more results in an increase in prices.
How does inflation affect your investments?
Inflation is generally bad news for most investments but there are some exceptions. Investors tend to move away from speculative or higher risk assets and into safer ones, as inflationary periods can coincide with greater economic uncertainty and the prospect of higher interest rates.
Interest rates are an important factor because they are the main mechanism central banks can use to try to reduce inflation. Higher rates make borrowing more expensive and saving more appealing, thus discouraging people from spending their money now and reducing some of the demand pressure in the economy.
What that means in practice is that investors prepare for expected interest rate rises by putting their money into assets with proven track records or rates of return. Commodities like gold and silver, bonds, and stocks in established companies with reliable revenue streams are most likely to increase in price. More speculative assets, like growth stocks or cryptocurrencies, might drop in value as investors move their money out of them.
How to protect against inflation
The best way to protect your investments from the impact of inflation is to create a balanced portfolio. That means putting your money into a variety of different assets so that any poor performance in one area is balanced by better returns from another. Below is a more detailed summary of the options available.
The best stocks for high inflation
Look for stocks that are likely to grow by more than the rate of inflation. If inflation is at 5% then you want to invest in companies that have the best chance of growing by more than 5% otherwise your money is actually losing value each year.
The best bet is to look for value stocks; companies that are trading at a discount compared to their fundamental business performance. This requires some time and effort to research but you want a business with reliable revenue streams, lots of assets, and few debt obligations.
Companies that specialise in consumer goods or are capital-light, such as communications, are a good place to start. It’s also worth thinking about what to avoid; speculative or popular industries where companies are valued based on future promise rather than current performance are often hardest hit when investors get cautious.
Invest in gold
Gold has long been seen as the best way to combat inflation. As it is priced in US Dollars, when the value of the dollar falls, each unit of gold becomes more valuable. Over time, a unit of gold is much more likely to preserve its purchasing power than a fixed amount of dollars would be.
However, it is worth noting that gold is a stable asset that doesn’t offer any yield. Investments like bonds or savings accounts (or dividend stocks) offer an annual rate of return so that you can grow your wealth in addition to the changes in value of the asset itself. Gold works more as protection than a way to actually increase your wealth in the short term.
Invest in real estate
Property is an option for those with the disposable income to afford it. House prices form part of many price indices that are used to measure inflation and so rising inflation usually corresponds with an increase in the price of property. If you own property, the value of your holding will increase along with inflation.
Like with all assets, there are some pros and cons to going down this road. Land and property are expensive, while rising interest rates make it even more so (by increasing monthly mortgage repayments). However, if you have the means to own property and rent it out it can provide a reliable income stream that’s relatively inflation-resistant.
Alternative investments
New asset types, such as cryptocurrency, are another option. These operate outside of the traditional financial system and so aren’t affected by inflation and interest rates in quite the same way. Bitcoin is often called ‘digital gold’ and should, in theory, maintain its value as fiat currencies are devalued by inflation.
Cryptocurrency is a new asset class, however, and there isn’t as much historical performance to go on as there is with ancient investments like land or gold. Many individual coins have acted more like speculative growth stocks during inflationary periods and suffered accordingly, which means you should be careful about which projects you invest in.
The best places to invest
A part of being a successful investor during inflationary periods is choosing the right trading platform. The brokers below are the safest and best places to invest and offer plenty of help to beginners as well. Click on any of the links below to get started.
A quick recap
Inflation makes the money you have today worth less tomorrow. It’s caused by a combination of factors like an increase in the money supply, rising production costs, and consumer spending, corresponds with broad economic uncertainty, and often prompts a rise in interest rates.
To combat inflation you need to invest in a range of different assets so that you aren’t exposed to the performance of one particular stock or industry. There are specific assets, like gold or real estate, that traditionally perform well or you can look for stocks on a sound financial footing that have the potential to increase in value by more than the rate of inflation.
At Invezz you can learn how to invest into different economic conditions, while you can also find out more about how to invest in specific assets, like Bitcoin or gold. Finally, an important part of being a successful investor is knowing what’s going on in the markets right now and you can follow that with our up-to-date news and analysis.
More stock investing guides
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