How inflation affects financial markets

How inflation affects financial markets

Reading time: 7 minutes

Inflation plays an important role in shaping financial markets. As the cost of goods and services changes, so can consumer spending, business expenses, corporate earnings and interest rate expectations.

These developments can influence the performance of stocks and other asset classes, creating changing conditions for investors. Understanding the causes of inflation and its effects on financial markets can help you better assess market movements and manage investment risks.

What is inflation?

The average person may not be able to formally define inflation, but its effects are easy to recognise: the rising prices of goods and services and the gradual loss of a currency's purchasing power. Inflation can also increase the cost of raw materials, labour and other business expenses, potentially putting pressure on companies' operating costs.

In economics, money serves three main functions: it acts as a unit of account, a medium of exchange and a store of value. Its purchasing power is influenced by the general price level. As prices rise over time, each unit of currency buys fewer goods and services, reducing its purchasing power.

Money is not the only way to store wealth. People can also hold assets such as property, bonds and stocks, which may help preserve or grow wealth over time. However, unlike money, these assets generally need to be sold or converted into cash before they can be used to purchase goods and services. Inflation can also affect these asset classes differently, influencing their market prices and potential returns.

What causes inflation?

Inflation can be driven by several factors, including cost-push inflation, demand-pull inflation and expansionary monetary or fiscal policies.

Cost-push inflation occurs when the cost of producing goods and services increases. Higher prices for raw materials, energy, labour and other inputs can raise businesses' operating costs. If companies pass these additional costs on to consumers, the general price level may rise. This can happen even when consumer demand remains relatively stable.

Demand-pull inflation, on the other hand, occurs when demand for goods and services grows faster than the economy's ability to supply them. When consumers and businesses compete for limited goods and services, prices may increase.

Monetary and fiscal policies can also influence inflation. Central banks may lower interest rates or introduce other measures to ease monetary conditions, encouraging borrowing and spending. Governments can also contribute to higher demand through expansionary fiscal policies, such as increasing public spending or reducing taxes. Depending on economic conditions, these measures can add to inflationary pressures.

Financial markets respond to these developments because inflation influences interest rates, corporate earnings, borrowing costs and expectations about economic growth. As a result, inflation data can trigger price movements across multiple asset classes, particularly when published figures differ from market expectations.

Negative effects of inflation

For businesses, a sudden spike in inflation can create significant challenges. Higher prices for raw materials, energy, labour and other inputs can increase operating costs and put pressure on profit margins. While some companies can pass these additional costs on to customers, others may struggle to do so, particularly when consumer demand is weak. As a result, both businesses and consumers may need to adjust to a higher pricing environment.

For consumers, inflation gradually erodes the purchasing power of money. In other words, the same amount of cash buys fewer goods and services over time. While periods of strong economic demand can support job creation, persistently high inflation can also squeeze corporate profits and increase operating expenses. This may discourage businesses from hiring additional employees or investing in new technologies and expansion.

The relationship between inflation and stock prices can be more complicated. Inflation affects companies differently depending on their operating costs, pricing power and exposure to interest rates. Some businesses may maintain or increase their profitability during inflationary periods, while others may experience pressure on earnings. This makes it important for investors to consider the broader economic environment rather than assume that all stocks will react in the same way.

Higher-than-expected inflation can put downward pressure on equity prices, particularly when it raises concerns about interest rate increases or slower economic growth. However, the relationship is not always inverse. Stock prices can rise or fall depending on how inflation compares with market expectations and how investors assess its potential impact on corporate earnings.

How inflation affects stock prices

Some of the factors through which inflation can affect stock prices include:

• Economic slowdown: Persistently high inflation can reduce consumer purchasing power and spending, potentially slowing economic growth and affecting corporate revenues.
• Pressure on corporate earnings: Rising production, labour and operating costs can reduce profit margins, particularly when companies cannot pass these increases on to customers.
• Higher interest rates: Central banks may raise interest rates to contain inflation. Higher borrowing costs can weigh on business investment and consumer spending, while also making interest-bearing assets more attractive relative to equities.
• Lower real returns: Inflation reduces the purchasing power of investment returns. Investors may therefore seek higher nominal returns to maintain their purchasing power, potentially affecting demand for certain stocks and other assets.

How to manage inflation as an investor

Inflation can significantly affect your investment portfolio by reducing the purchasing power of money and influencing the real returns on your investments. For example, the same amount of money may buy considerably fewer goods and services ten years from now if prices continue to rise. While investors cannot control inflation, they can consider different approaches to managing its potential impact. These may include diversifying across asset classes and considering investments that have historically been used as potential inflation hedges, such as gold. However, no asset offers guaranteed protection against inflation.

Diversification across different asset classes, such as equities, bonds, real estate and commodities, can help spread exposure to different market conditions. Investors may also consider index funds as a way of gaining exposure to a broader range of companies or markets, depending on the underlying index.

Historically, value stocks have outperformed growth stocks during some periods of high inflation, although this relationship is not consistent across all market conditions. Value stocks are shares that appear to trade below their estimated intrinsic value. They are often associated with established companies that generate relatively consistent cash flows, although this is not always the case.

One reason value stocks may perform differently from growth stocks during inflationary periods relates to how investors value future earnings. Growth stocks are often valued partly on the expectation of higher earnings in the future. When interest rates and discount rates rise, the present value of those expected future cash flows generally decreases. By comparison, companies generating stronger cash flows today may be less sensitive to changes in discount rates.

Ultimately, how investors respond to inflation depends on their investment objectives, time horizon and risk tolerance. Long-term investors may consider companies with strong pricing power, as these businesses can be better positioned to pass higher operating costs on to customers and protect their profit margins. From a shorter-term perspective, unexpected inflation and changes in interest rate expectations can increase stock market volatility. This may create potential trading setups for investors and traders, although greater volatility also brings additional risk.

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We can’t deny the fact that inflation will always be an economic fact, whose impact is felt in every nook and cranny of the financial market. But by understanding how inflation interacts with economic growth, market expectations, and central bank policy, investors can develop a more intelligent view of changing market conditions and what their next trading move will be.

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