What does rising inflation do to the stock market?

When inflation rises, it generally puts downward pressure on the stock market, at least in the short-term.

‘Downward pressure’ means market values will either rise more slowly than usual or go backwards.

In a moment, we’ll explain how you might respond to an atmosphere of rising inflation. First, though, let’s discuss the three main reasons why this is generally a negative for the market.

Rising inflation triggers rate increases

When inflation rises, central banks, like the Reserve Bank of Australia and the US Federal Reserve, often respond by raising official interest rates, to take heat out of the economy. That, in turn, has several effects:

• Consumers have less disposable income, so they reduce their spending, which, in turn, means businesses make fewer sales and post lower profits.
• Businesses have to pay more for supplies, which reduces their profits.
• Businesses have to pay higher borrowing costs, which reduces their profits.

And lower profits generally means lower stock market values.

Rising inflation spooks investors

The second reason is more straightforward – rising inflation creates fear and uncertainty, which, in turn, affects demand for equities.

Rising inflation forces investors to take more risks 

Finally, rising inflation affects the market by making it harder for investors to get the sort of return they want, which, in turn, encourages some investors to shift their money to other assets. If investors want to earn an annual return of 6.5% after inflation, that means they’d expect the stock market to return:

• 8.5% if inflation was 2%
• 9.5% if inflation was 3%
• 10.5% if inflation was 4%

Generally, you can’t earn a higher return without taking more risk, so some investors might decide they’d be better off putting their money into property or gold.

Five investment options to think about in times of rising inflation

So how should you respond when inflation starts rising?

Unfortunately, there’s no one-size-fits-all answer, as it depends on your individual circumstances and the particular economic conditions that exist at the time. But here are some options that some investors favour:

• Establish a diversified portfolio, because while some stocks will be negatively affected by inflation others will benefit.
• Choose ‘value’ stocks over ‘growth’ stocks, as value stocks tends to deliver profits in the shorter-term (when money is worth more) while growth stocks tend to deliver profits in the longer-term (when that money has been eaten up by inflation).
• Invest in companies that produce commodities like food or energy, because commodity producers tend to find it easier to pass on price rises to their customers (and therefore protect their profit margins).
• Invest in gold, which is often regarded as a safe haven in times of rising inflation.
• Invest in a REIT (real estate investment trust), because property prices and rents tend to increase when inflation rises.