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Evaluating the Performance of Equities in Inflationary Times

Market sectors and companies experience varying impacts from inflation, but investors should consider the strategic, longer-term view 

Inflation soared to its highest level since 1982 in January 2022, reaching 7.5% on an annual basis. The impact on everything from groceries to oil prices has reverberated through the financial markets and received extensive media coverage. Even the bankers of the Federal Reserve have admitted they were wrong about inflation

An inflationary period that many economists expected to be transitory has become “stickier” than most analysts predicted. Broadly rising inflation has complicated recovery for an economy already hit by new virus variants, supply chain disruptions, and higher oil prices. 

Worries about inflation coupled with the stock market’s continued volatility are causing some investors to rethink their asset allocations. But many seasoned market watchers—and significant historical data—point most investors toward staying the course. Here are some reasons why it may be wise to stand by equity allocations in a portfolio—if they already make sense for your investing goals and time horizons. 

Inflation and the US equity market

When consumer prices rose at the start of 2022, the equity markets responded with volatility. But it is worth keeping in mind that sustained periods of high inflation have been rare. 

Prolonged and/or high inflation can impact the equities market negatively—directly or indirectly—in several ways:

  • Companies’ profits may fall if rising prices cannot keep up with rising input costs, and
  • Real bond yields may rise, increasing the discount rates applied to future cash flows and stunting company valuations.
  • Prolonged high inflation can curtail company investments, including in new employees, and the impact of fewer jobs on consumer spending may eventually harm the economy and valuations.

Theoretically, companies’ prices for goods and services and their resulting revenue and earnings should keep pace with inflation. But as with many things related to the pandemic, this inflationary period and its effects are unprecedented and resistant to expert consensus. For example, one financial analyst argues that what’s happening is a “fundamental regime change” for both inflation and interest rates, in which “declining interest rates and benign inflation” reverse, with implications for many asset classes. 

Fighting rising inflation is one of the rationales behind the Federal Reserve’s pledge to raise interest rates in 2022. And many investors worry that higher interest rates will negatively affect overall earnings and depress valuations. But even the Fed’s bankers are divided on that issue.

After stock valuations drove the equities market to record heights in 2021, particularly in the technology sector, many investors started to fear widespread losses because of rising inflation. Others are clinging steadfastly to the belief that this too shall pass, and it is imprudent and even unwise to rebalance a portfolio based on current conditions.

It’s conceivable to agree with both schools of thought. High inflation can negatively impact the stock market. But some stocks tend to perform better than others in an inflationary economy, as we’ll cover below. And overall, equities usually do ok—and well over the long haul. Successful long-term investors tend to look at these historical patterns and exercise patience. 

Conventional wisdom and historical precedents 

When the effects of COVID-19 hit the supply chain, and prices for consumer goods and services soared for numerous reasons, inflation became a major topic of concern. But historical data suggest that some of this fear isn’t justified, at least long term. Studies of the impact of inflation on stock returns “have often produced conflicting results, though “most researchers have found that higher inflation has generally correlated with lower equity valuations.” Nevertheless, stocks keep up with rising prices better than some securities. And equities overall always bounce back, given enough time, even after rare periods of prolonged high inflation or stagflation. 

Both expectations of stock market volatility and realized volatility have been trending upward in 2022. But recent activity, as reported in Forbes, shows that certain equity sectors benefit from or at least keep pace during an inflationary period. Stocks that are historically more likely to benefit from high inflation include those of banking, insurance, consumer staples, and energy sector companies. Forbes calls these “Inflation Stocks,” and they have recently marginally outperformed the S&P 500, which returned about 26% over the same period. 

Equities fare better than bonds; some might even outperform commodities and real estate. And in contrast to specific inflation hedges like commodities—which are a successful move if an investor correctly guesses which way prices will go and for how long—stocks overall tend to perform well long-term regardless.

Turning off the noise

It’s not perfectly clear whether the US economy is experiencing “transitory inflation” or something that will last far longer than initially predicted. Experts disagree, and the focus on inflation and its perceived consequences is compounding market volatility and investor anxiety.

But many experts do agree that it’s never a good time to make rash decisions concerning asset allocations in an investment portfolio. Many stock valuations will reflect the uncertainty surrounding rising inflation and interest rates in the short term. But even if inflation and interest rate worries prove substantial and durable, history has shown that equity valuations keep up better than some investment classes. And where they don’t, the equity market has always bounced back overall.

It is also important to keep in mind that deflationary pressures and “stagflation” — periods of inflation with low growth — can be more harmful to assets than what is currently happening in the economy.

Finally, a stay-the-course approach with equities only makes sense if it matches an individual’s goals, time horizon, and portfolio. For example, if someone is at a stage of life where they need less risk and more income, they may not be prepared to ride out market volatility. And they likely shouldn’t have heavy exposure in equities anyway. 

In every case, it’s best to devise a comprehensive strategy customized to each person’s goals and situation. Then, once that’s in place, avoid making rash moves based on uncertain predictions on what will or won’t happen with inflation. 


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