How does inflation impact the stock market?

What is inflation?

Inflation refers to the increase in prices of goods and services within an economy. 

The most common way this is measured and reported on is through the consumer price index or CPI. The CPI measures the increase or decrease in prices of a variety of consumer goods and services.  

Those goods and services include everything from food, clothing, housing, fuel, transportation, medical services, and other living expenses people incur as part of their day to day lives.  

What causes inflation

There are 3 key causes of inflation that you should be familiar with. These include: demand-pull inflation, cost-push inflation, and inflation expectations. 

  • Demand pull inflation is when the demand for goods and services exceeds their total supply causing prices to increase. Economists refer to this as ‘too many dollars chasing too few goods’. 
  • Cost-push inflation is when the supply of goods and services within an economy declines, while demand for those goods and services remains the same, causing prices to increase.  
  • Inflation expectations can also cause prices to increase over time. This is because consumers and companies base current financial decisions on what they expect the world to look like in the future. 

For example, if a company like Apple expects the price of the components used to make an iPhone will increase in the future, management might preemptively raise the price of its iPhone to offset those ‘expected’ cost increases. 

How inflation impacts the stock market

The way all of this impacts the stock market and the share prices of individual companies primarily comes down to how central banks respond to inflation, namely by raising interest rates. 

The role of central banks

When inflation is high – or above where central banks want it to be – you will likely see central banks raise interest rates. 

By increasing interest rates, central banks are betting that consumers and businesses will borrow less (take out less debt) and decrease spending. Put another way, the expectation is that by increasing interest rates, demand will fall. 

Stocks vs bonds

With higher interest rates, stocks become less attractive to investors. This not only might see capital flow away from stocks (people selling their stocks), but it will likely see less capital flow into stocks (people buying stocks). These factors can put downward pressure on share prices. 

The key reason that stocks become less attractive to investors when interest rates are higher is because government bonds, become more attractive, because they pay or yield investors more while being ‘less risky’, in a high interest rates environment.

Looking at the other side of this equation, while stocks may be down right now, it’s worth remembering that out of downturns stocks tend to rise. In fact, according to research, two years after a recession stocks on average rise 20%. 

The impact of debt

In real terms, higher interest rates also means companies face higher debt costs, which can lower company earnings. Again, lower earnings or the expectation of lower earnings might make stocks less attractive to investors, leading people to sell stocks or not buy stocks.  

While companies with strong balance sheets like Apple might be relatively unaffected by higher debt costs, companies with poor earnings or relatively high debt levels are likely to be more adversely affected by higher debt costs.  

How inflation has impacted Australians 

Syfe’s 2022 investor pulse – which surveyed over 1,000 Australians – shows that Australian investors have reacted with mixed emotions to rising inflation. 

Here’s how investors responded to the question: ‘Given that inflation and interest rates have started to rise from earlier this year [2022], I have or intend to.’

Source: Syfe

Here’s how investors responded to the question: ‘Given that inflation and interest rates have started to rise from earlier this year, how do you feel about your main investment goal?’

Source: Syfe

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This article/webinar is brought to you by Syfe Australia Pty Ltd., CAR number 1295306 of Sanlam Private Wealth Pty Ltd (AFSL 337927). Disclaimer: Investing involves risk including the risk of losing your invested amount. We do not provide personalised advice or recommendations.  Any information we provide is general advice and current at the time  written. Please speak to your Financial or Tax adviser for personal advice. Any reference to an investment’s past or potential performance is not an indication of any specific outcome or profit.