Stocks and Inflation

Until recently, inflation and interest rates had been on a secular downtrend after peaking in the early 1980s. For the first time in four decades, however, inflation is rapidly approaching double digits and posing a credible threat. The market is not overly concerned that inflation will persist long-term, as it is discounted to return to the low 2-3% levels to which we’ve become accustomed. 1 But with Russia’s invasion of Ukraine, tight housing and labor markets, and lingering supply shortages, inflation may continue to surprise to the upside despite the Fed’s plans to tighten.

Many investors seem to think that stocks are a good inflation hedge, but historically they have been the opposite – slightly underperforming cash during rising inflation environments. We believe investors should not rely on this asset class to protect them should we return to a 1970s-type economic climate.

Conceptually, Rising Inflation Is Bad for Stocks

A company’s value is primarily driven by its long-term profitability and the discount rate used to value those future cashflows. Inflation increases the cost of inputs (commodities, labor, rent, goods and services, etc.) and capital expenditures, as well as the cost of financing operations and investment due to higher interest rates. Most businesses are unable to pass on all these cost increases by raising prices or can do so only with a lag, so margins are squeezed. Inflation can also hurt demand, as consumers who pay more for gas, food and housing have less money for discretionary spending. In addition, higher inflation is typically associated with higher interest rates (as central bankers tighten monetary policy to bring inflation down), which can make major purchases, often bought with borrowed money like cars and homes, less affordable. Higher interest rates can also produce a downward pressure on stock prices because of an increase in the discount rate used to value a company’s future cash flows, resulting in lower valuation multiples.

Finally, inflation can also impact a company’s operations. Inflation can create substantial uncertainty, making it difficult for companies to plan and invest for the long term. And if it’s caused by supply shocks, that can hamper production, not just make it more expensive, as we’ve witnessed during the pandemic and the Russia-Ukraine war.