CWG Insight Series: How Inflation Impacts Your Investments

• Inflation erodes the purchasing power of consumers and has the potential to put significant downward pressure on stock prices.
• The economic reopening has caused inflation to spike to the highest rate since 2008, according to Fed data.
• The Fed’s current outlook is that the inflation is temporary
• Volatility could increase for the rest of the year as investors gauge inflation and the timing of any actions by the Fed

In the wake of the pandemic, the U.S. economy is booming as Americans’ spending habits start to resemble what they were back in 2019. The transition from a stay-at-home economy to a reopening economy (with pent up demand) has not been smooth in many areas. You likely have read about, or been directly impacted by, labor shortages and supply chain issues. These issues have caused prices of some goods and services to increase recently, resulting in a spike in inflation.

What is inflation? Well, baseball Hall of Famer Yogi Berra once famously quipped “A nickel ain’t worth a dime anymore”. A much better definition is: The declining purchasing power of a dollar over time, reflected in the general increase in prices for goods and services.

Inflation itself is not bad. The Fed currently targets an annual inflation rate of 2% for a healthy economy. The problems arise when inflation starts outpacing wage growth by a significant enough margin that it results in people having lower disposable incomes. If households need to spend a higher percentage of their paychecks on the essentials like rent, food, gasoline, etc., they will be spending less on discretionary goods, services and entertainment. With consumer spending representing roughly two-thirds of annual U.S. GDP, lower disposable incomes can lead to the economy slowing down considerably.

While most people understand how inflation impacts their pocketbooks, understanding how it impacts their investments is lesser known. Increases in the rate of inflation are viewed as a considerable negative for the stock market as inflation hurts many key areas of most businesses’ financials.

Inflation increases the borrowing costs for businesses. It also increases input costs such as materials and labor. Additionally, demand for many types of goods or services produced by companies may decrease while these costs are rising. The combination of higher costs and lower sales for businesses can result in downward pressure on stock prices.   

Besides wreaking havoc on a company’s financials, inflation also erodes the value of earnings that are produced by the company. At a fundamental level, stocks are valued by the amount of earnings the company will produce years into the future. Because of this method of valuation, growth stocks usually perform much worse in times of rising inflation compared to value stocks.

The Fed is responsible for keeping inflation in check by adjusting key interest rates higher that can decrease inflation. According to Fed data, the inflation rate spiked to 5% in May, which is the highest rate since 2008. This spike initially rattled investors, but the consensus is currently that the increase is only temporary due to the economic reopening. The Fed has held off using any countermeasures thus far.

Wall Street analysts and economists are closely monitoring the Fed’s comments and actions, looking for signals as to when they will taper back their monthly bond purchases and when they plan on increasing interest rates. If the Fed acts too soon, they risk suppressing the economic rebound. If the Fed acts too late, they risk serious inflation problems.

The debate of when, and to what degree, the Fed acts to curb inflation will be weighed feverishly by investors for the next year. Stock market prices will respond accordingly as bulls and bears state their cases. Historically, the fear of inflation alone has been enough to cause the market to pullback. We saw an example of that in May, but stocks have since rebounded and hit new all-time highs.

Overall, inflation not only hurts your monthly budget, but it also can cause your investments to decline if the increase is sharp and sustainable. Fortunately, the current outlook indicates that the Fed will be able to manage the situation without too much interference to the economy, your pocketbooks or your investment accounts.

We hope you are enjoying your summer with friends and family.

Steve Lindgren - Chief Investment Officer