How Does Inflation Impact the Stock Market?

This is a question I’ve been getting a lot recently, and for good reason. While I am currently writing this in June of 2024 — and we're post 2022 and 2023, when the inflation came roaring back after the COVID-19 pandemic — we believe that inflation tends to be “sticky.” Meaning the effects of inflation have a tendency to linger in the stock market, and it could linger well into 2025.

If you're asking this question, you are probably an active investor doing your homework before you dive into maybe a new idea or a new investment — we applaud this, because an educated investor is a smarter investor. Or perhaps you're just sick and tired of paying more at the grocery store and at the gas pump, and you're hoping that I’ll tell you immediate relief is on the horizon. 

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No matter which of those two categories you fall into, you’re in the right place. There are five key points you need to know about, when it comes to understanding how inflation impacts the stock market.

Inflation Affects the Economy Immediately

This is not something where we see a delayed reaction. Inflation hits the U.S. economy immediately. Why? Consumer purchasing power decreases as prices increase. That's just the bottom line of what's going on with inflation. And as those prices increase, as we all know this firsthand, our ability to buy stuff starts to decrease. 

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This then often leads to reduced spending, which then lowers companies revenues, which then affects their earnings outlook, which tends to lower their stock prices … you see my point.

Interest Rates Start to Rise

Interest rates start to rise as the Federal Reserve raises interest rates to push inflation out of the economy. As those borrowing costs go up, business owners, entrepreneurs, large corporate executives, and everybody in between start taking less risk. They start saving money and holding onto it because the future gets murky and we don't know how long this is going to last.

It Impacts Corporate Earnings Directly

The stock market is very sensitive to changes and corporate earnings expectations. As prices increase, costs of raw materials, labor, and other inputs start to affect the expenses of companies — which lowers their profit margins and that eventually lowers their earnings.  Again, that lowers their stock price, their pricing power. 

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Now, if a company has significant pricing power, they can weather the storms of inflation very differently. Those companies are much stronger than those that don't have significant pricing power. For example, companies that produce consumer staples have good pricing power because we all go to the grocery store during times of inflation.

We got to continue to eat, but we may not buy a new car during times of inflation if the prices of those cars have gone up and we're spending money elsewhere. 

ENergy + Material Sectors Tend to Do Well

Energy and material sectors tend to do well because commodity prices (such as oil and metals) tend to rise during inflation. As those prices rise, energy companies tend to grow more profitable. 

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Companies that produce consumer staples, which we just talked about — companies that sell groceries and gas, because we still have to buy these or our society — are built on products we have to buy. These have higher pricing power than say a car manufacturer or a brand new, really sexy, and cool looking EV. And they don't have a lot of pricing power just yet, which means technology and growth stocks tend to do poorly.

These high flying companies can be very sensitive to prices and interest rates at, as we saw in 2022. Back then, tech companies absolutely got smoked, but they roared back in 2023, demonstrating the resiliency of the current U.S. economy. 

Sentiment Down, Volatility Up

Inflation puts everyone in a bad mood, which lowers investor sentiment, and that leads to market volatility. Now, market volatility in today's world is caused by traders — specifically, options traders, futures traders and interest rates. Interest rates cause volatility in those areas, as well. So, historically investors' sentiment could cause market volatility. 

Now, trader sentiment and traders costs cause market volatility, but also overall uncertainty in the future. High inflation tends to cause all of us, from individuals to the largest corporations, to hold what we have for the time being  — to kind of hunker down and weather the storm, which also causes us to run to safety.

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Historically, during times of inflation, you run the bonds, you run to gold. But if you did this in 2022, you got hit pretty hard because gold priced in dollars cratered because the strength of the dollar bill increased so dramatically. On top of that, U.S. Treasury bonds had one of the worst years in history in 2022.

Long-Term Considerations for Inflation

Stocks have provided protection against inflation simply because companies can increase their prices, grow the nominal value of their asset, and their earnings tend to rise with inflation. And so, historically, the U.S. stock market has outgrown inflation over top, but you can also incorporate a sector rotation. Investors can rotate between those high-fi tech stocks and into consumer staples, or rotate into gold or rotate into bonds during times of uncertainty.

We've written a lot about this particular topic, but I urge you to develop and test a rule set before you dive into a sector rotation strategy. You don't want to get halfway into a rule set and have to rotate and get hammered because you don't know what you're doing. 

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When you look at history, you will see times of inflation. You’ll also see times of hyperinflation, which we're far from today. You can study what worked, you can study what did not. Use history to show you what not to do; how not to fall into the trap of following the crowd. 

Today, they will get smoked. “The crowd” usually gets hurt in times of change, and we're going through a regime change in this 15-year period (2008 to 2023) of ultra low interest rates into a period of higher interest rates. We don't know how long this period's going to last. But this is the moment when we should go study history — because it is changing in real time for us today, and the past has much it can teach us.\