How Does Inflation Affect Stocks?

How Does Inflation Affect Stocks?

Inflation has become an obsession for professional investors and consumers alike in 2022.

Concerns about the economic impact of rising prices—and their remedy, higher interest rates—have weighed on stocks, plunging the S&P 500 into a bear market for a spell in June.

At first glance, it may not be obvious whether rising prices are bad for stocks. While elevated inflation can have severe negative consequences for the broader economy, it isn’t a disaster for investors.

The current spike in inflation has lasted longer and been more challenging than anyone expected, least of all the Federal Reserve. Fortunately, data suggests peak inflation may have arrived, although there’s little doubt that elevated prices should remain a lingering problem for stocks.

How Does Inflation Work?

Inflation is the broad, gradual increase in prices across an entire economy. When prices rise, inflation lowers the purchasing power of money.

Central banks consider a moderate amount of inflation necessary to sustain economic growth. The Fed aims for a long-term target of 2% annual inflation growth, for example, as measured by the core personal consumption expenditures price index (PCE).

However, when inflation runs too high for too long, it’s a sure sign that an economy is overheating.

Hot inflation indicates that consumer demand is outpacing supply, driving prices higher—so-called demand-pull inflation. Alternatively, supply chain problems may make goods more expensive—that’s cost-push inflation.

Either way, an overheating economy will eventually push prices to the point where spending declines. And when spending falls, the economy can easily tumble into a recession. In fact, an overheated economy has been one of the most common recession triggers in the U.S. since World War II.

When Inflation Rises, Interest Rate Hikes Follow

Higher inflation by itself isn’t necessarily bad for stock prices. Rising prices boost corporate profits, especially if companies can pass on higher input costs to their customers via price hikes.

Higher interest rates are an entirely different story for stocks when inflation gets out of hand. The remedy is higher interest rates, and rising rates make credit more expensive for companies and consumers, discouraging them from spending and investing.

Jamie Cox, managing partner for Harris Financial Group, says the negative stock market trend in 2022 is actually more about interest rates than inflation.

“Markets tend to worry more about the remedy for inflation—interest rate increases—than inflation itself,” Cox says. “Markets discount earnings and make adjustments to multiples based on the level and rate of change in interest rates, so the cure shows up pretty quickly in markets.”

Inflation’s Impact on S&P 500 Stocks

Inflation in 2022 hasn’t hurt the business performance of the companies in the S&P 500 nearly as much as it has hurt their stock prices.

S&P 500 component companies have reported 6.7% earnings growth and 13.6% revenue growth in the second quarter of 2022, but you wouldn’t know it by looking at the S&P 500 index’s poor year-to-date performance.

Remember, the stock market is a real-time reflection of investor sentiment and aggregate expectations for the future rather than a representation of current economic conditions.

Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, says the 2022 stock market weakness has been driven by fears about the Fed’s monetary policy response to elevated inflation.

“As the consumer price index (CPI) or PCE numbers remain above 2% to 3%, the Fed will continue to raise interest rates, and all things being equal, higher interest rates are bad for the stock market,” Zaccarelli says. “This year, we’ve seen the stock market sell-off based on concerns that higher interest rates would lead to a recession.”

A new Charles Schwab survey found that 74% of U.S. stock traders believe a U.S. recession is coming before the end of 2022.

U.S. gross domestic product (GDP) growth has been negative in the first two quarters, a trend that typically indicates a recession. However, the labor market has remained strong, and Fed Chair Jerome Powell said in July that he does not believe the U.S. is currently in a recession.

Inflation-Resistant Stocks

Rising interest rates are generally bad news for most stocks, but certain ones are negatively impacted more than others.

Growth stocks are particularly sensitive to rising interest rates. Fund managers and financial analysts use discounted cash flow models to value a company’s future earnings. The higher interest rates are today, the less value these models assign to a growth stock’s future cash flows.

So far in 2022, the Vanguard Growth Index Fund ETF (VUG) is down 18.8% year to date, while the Vanguard Value ETF (VTV) is down just 5.1%.

Read More: The Best Growth ETFs

Certain stock market sectors have also performed relatively well during periods of elevated inflation. Since 1973, energy stocks have been the top-performing sector during periods of high and rising inflation.

This trend has certainly held true in 2022. The Energy Select Sector SPDR ETF (XLE) is up 35.1% year to date, and most of the top-performing stocks in the S&P 500 this year are oil and gas companies.

Consumer staples, financial, and utility stocks have also historically held up well when inflation has reared its head.

Bank of America recently screened for S&P 500 stocks with the highest positive correlations to inflation going back to 1975. Metals and mining company Freeport-McMoRan (FCX), chemical company Mosaic (MOS) and oil and gas company Devon Energy (DVN) topped their list of pro-inflation stocks.

Has Inflation Peaked?

On August 10, investors got some good news from the Labor Department, which reported the CPI rose 8.5% year over year in July, down from its 9.1% gain in June. The pullback could be a sign inflation has finally peaked.

The S&P 500 predictably rallied more than 2% the day the CPI data was released, but Bill Adams, chief economist for Comerica Bank, says investors aren’t quite out of the woods just yet.

“With the economy much cooler than in 2021, inventory levels higher, and gas prices down in the first 10 days of August, inflation is probably past the peak,” Adams says.

However, he says an ongoing energy shortage in Europe could send oil prices surging once again when the economy moves into the winter months.

“Inflation is likely to be stuck above 5% through the winter as utility prices stay high and global supplies of petroleum products stay tight,” Adams says.

The Fed Will Keep Raising Rates

In addition, just because inflation may have peaked doesn’t mean interest rates have peaked.

According to CME Group, the bond market is currently anticipating the Federal Open Market Committee (FOMC) will raise interest rates by at least 50 basis points (bps) in September.

The market is also pricing in a 58.5% chance that the Fed will raise interest rates by at least 125 bps between now and the end of the year.

The next major inflation data point for investors is due on Aug. 26 when the Bureau of Economic Analysis releases its July PCE inflation reading.

If year-over-year PCE growth drops below the 6.8% level reported in June, it would be further evidence to investors and the Fed that U.S. inflation has potentially peaked.

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