How to Benefit From Inflation in the Stock Market

Inflation is often viewed as a bad thing for the economy, however, there is always a bull market in some parts of the stock market.

What Inflation Means for Stocks

When it comes to comparing inflation and stock returns, research has shown that lower equity prices correlate with high inflation.

Examining the overall market using the S&P 500 index, we see that the highest inflation-adjusted returns occur when inflation is at normal levels of around 2% to 3%.

While these numbers are important to look at for overall equity valuations, there is always a bull market in some sectors of the stock market.

Most financial professionals would recommend that you buy and hold solid companies or an index for a long period of time, but fail to mention that during times of economic distress your short-term returns can be painful to look at.

As a nimble investor, it is important to remain flexible and always seek out stocks and sectors that are primed to outperform the overall market.

What is Inflation?

Inflation is essentially when your dollar is not able to pay for as much as it did in the past. Inflation occurs when the purchasing power of a currency declines over time.

This is measured in a few different ways, the most popular being the Consumer Price Index or CPI. The CPI is measured each month using 80,000 items in a fixed basket of goods that Americans generally buy in their everyday lives. There is some controversy on what items should and should not be included in this measure, but it is the most widely adopted way to determine how much purchasing power has increased or decreased over time.

Each month the CPI comes out as a percentage increase over the last 12 months. The Federal Reserve targets an inflation rate of about 2% because they consider this to be the perfect number for a strong economy.

As this number increases or decreases, the government and/or the Federal Reserve may use their tools to stimulate the economy known as fiscal policy and monetary policy respectively.

While these tools were created to maintain a stable economy, the actions of the Federal Reserve in response to the Covid-19 pandemic may have sparked the high inflation rates seen after rates were lowered and government spending was increased.

What Causes Inflation?

There is a multitude of ways that inflation can be caused such as production costs, supply, demand, fiscal policy, and monetary policy. Inflation is a complex topic so a combination of these factors can cause it as well. To grasp the concept of inflation better, you must put yourself in the shoes of a business.

• Production costs

Production costs such as raw materials and wages can be a reason that inflation occurs. As a business owner, if you are required to pay your workers a higher salary, you naturally will increase the price of your products and/or services to compensate for it. The same concept applies to the cost of raw materials because if you are required to pay more to produce a product you will most likely pass the cost down to the consumer.

• Supply & Demand

When demand for a product or service increases a business may want to raise its prices to maximize its profit potential. Aside from profits, if something is priced too low then demand might skyrocket causing supply-side issues for the business. An example of a supply and demand issue is the rapidly increasing semiconductor market. Chips are used in an abundance of items nowadays such as gaming, cars, phones, and even bitcoin mining. There is both high demand and low supply due to supply chain issues that stemmed from the Covid-19 pandemic.

• Fiscal policy

Not to be confused with monetary policy, which is controlled by the Federal Reserve, fiscal policy refers to the use of government spending and tax procedures to influence economic conditions.

Fiscal policy is largely based on the studies of John Maynard Keynes, who argued that recessions are caused by deficiencies in aggregate demand. More specifically, the consumer spending and business investment portion of it.

The government can either employ expansionary fiscal policy or contractionary fiscal policy.

Expansionary fiscal policy occurs when the government lowers tax rates and increases government spending to increase aggregate demand. This is often implemented during a recession. While this may sound great, expansionary fiscal policy can be a major cause for inflation because it will give consumers more money and cause increased demand.

The Federal Reserve can also employ expansionary monetary policy by lowering interest rates, which will also result in inflation.

Contractionary fiscal policy is when the government raises tax rates and cuts government spending. Contractionary fiscal policy is employed during inflationary times. Both must be used in moderation or else economic conditions can get out of hand.

Which Sectors Perform Well During Inflation?

Periods of high inflation do not provide much benefit to the average consumer. Investors, on the other hand, may see a boost in some of their assets within sectors that happen to benefit from inflation. Examples of those who benefit may include companies in the energy sector, consumer staples, and healthcare.

These sectors do well because they provide inelastic goods and services. Inelastic means the demand does not lower as easily as other sectors in rough economic conditions.

• Energy companies

Energy companies tend to benefit during periods of inflation because of the increased demand for consumer staples that commodities like oil are required to produce.

Many people may not realize it, but oil is required to produce thousands of items that we use every day.

Just to name a few examples for context, oil is required to produce roofing, deodorant, soap, fishing lures, fertilizers, toothpaste and so much more!

Energy accounts for about 7.3% of the CPI in the U.S., so when the demand for items goes up, the prices of oil and other commodities go up as well.

• Consumer staples

The consumer staples sector tends to do well during periods of inflation because they can easily raise their prices without hindering their demand too much.

An example of a consumer staple stock is Procter & Gamble which produces everyday items such as home care and baby care.

These types of products are considered inelastic meaning regardless of how bad times are economically people are still willing to pay for them as they are essential for everyday life.

Which Sectors Perform Bad During Inflation?

During periods of high inflation, there are several types of companies that are negatively affected. Generally, companies that are not profitable are hit the hardest such as growth stocks.

Another sector that does not do well during high inflation is the travel industry because many airlines are not profitable and need to buy lots of oil to provide their services.

• Growth stocks

Unlike consumer staples and value stocks that are generating consistent cash flow, growth stocks are generally still trying to get their business off the ground.

Due to the lack of profitability and cash flow, these companies are hindered because they usually have more debt. Debt is bad in high inflation environments because interest rates may rise and cause more interest expenses to companies that are already not making any money.

The combination of a lack of cash flow and increased interest expenses is enough to send a company underwater.

• Travel stocks

Companies in the travel sector such as the airlines rely on commodities like oil to keep their business running. Unfortunately, oil prices rise in high inflation environments which increases expenses for travel companies.

Additionally, many airline companies are already on thin ice when it comes to profitability like growth companies. The combination of increased costs of raw materials and slim profits can cause a company to perform poorly during high inflation.

Bottom Line

Navigating the markets is never an easy task, especially when inflation is rising, and few choices look like they will provide solid returns. At the end of the day, all investors need to determine their holding period and risk tolerance in the stock market.

With a holding period of over 10 years, you will probably be fine holding onto one of the major stock indexes or even solid companies that you believe in. While it may be easy to say that you are willing and able to hold your stocks for over 10 years, you never know what can happen that will force you to sell at a bad time.

Therefore, it is crucial to have a solid chunk of savings set aside before you decide to invest in the stock market. Not only is this a safe practice, but it is more of a psychological aspect that provides you with peace of mind and will lighten your mood if your investments happen to go south for a few years.

An extremely overlooked part of investing in the stock market is the mood swings that investors go through.

If the market just went straight up everybody would be making fortunes. Unfortunately, the reality is that to achieve amazing returns you must be nimble and able to withstand drawdowns without making a rash decision that will turn out to be a horrible mistake in hindsight.