Investors, the Federal Reserve, and businesses continuously monitor and worry about the level of inflation. Inflation—the rise in the price of goods and services—reduces the purchasing power of each unit of currency. Rising inflation can be harmful: input prices are higher, consumers may lose purchasing power unless their incomes rise, and monetary policy measures to contain inflation can damage growth and employment.

Inflation and the Value of $1

The chart below gives a sense of how dramatically inflation can reduce purchasing power.

This negative impact of rising inflation keeps the Fed diligent and focused on detecting early warning signs to anticipate any unexpected rise in inflation. The sudden increase in inflation is generally considered the most painful, as it takes companies several quarters to be able to pass along higher input costs to consumers.

Likewise, consumers feel the unexpected “pinch” when goods and services cost more. However, businesses and consumers eventually become acclimated to the new pricing environment. These consumers become less likely to hold cash because the value over time decreases with inflation.

High inflation can be good, as it can stimulate some job growth. But high inflation can also squeeze corporate profits with higher input costs. This causes corporations to worry about the future and stop hiring, reducing the standard of living of individuals, especially those on fixed incomes.

For investors, all this can be confusing, since inflation appears to impact the economy and stock prices, but not at the same rate. Because there is no one good answer, individual investors must sift through the confusion to make wise decisions on how to invest in periods of inflation. Some types of stocks tend to perform better during periods of high inflation.

Inflation and Stock Market Returns

Examining historical returns data during periods of high and low inflation can provide some clarity for investors. Numerous studies have looked at the effect of inflation on stock returns. Unfortunately, the studies have often produced conflicting results. Still, most researchers have found that higher inflation has generally correlated with lower equity valuations.

This has also been shown in emerging countries, where the volatility of stocks is greater than in developed markets. Since the 1930s, the research suggests that almost every country suffered its worst real returns during high inflation periods. Real returns are nominal returns minus inflation. When examining S&P 500 returns by decade and adjusting for inflation, the results show the highest real returns occur when inflation is 2% to 3%.

Inflation greater than or less than this range tends to signal a U.S. macroeconomic environment with larger issues that have varying impacts on stocks. Perhaps more important than the actual returns are the volatility of returns inflation causes and knowing how to invest in that environment.

Growth vs. Value Stock Performance and Inflation

Stocks are often subdivided into value and growth categories. Value stocks have strong current cash flows more likely to grow slowly or diminish over time, while growth stocks are likely to represent fast-growing companies that may not be profitable.

Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest rates, growth stocks are negatively impacted far more than value stocks. Since interest rates are usually increased to combat high inflation, the corollary is that in times of high inflation, growth stocks will suffer more.

The Bottom Line

Investors try to anticipate the factors that impact portfolio performance and make decisions based on their expectations. Inflation is one of the factors that may affect a portfolio. In theory, stocks should provide some hedge against inflation, because a company’s revenues and profits should grow with inflation after a period of adjustment. However, inflation’s varying impact on stocks tends to increase the equity market volatility and risk premium. High inflation has historically correlated with lower returns on equities.

Value stocks tends to perform better than growth stocks in high inflation periods, and growth stocks tend to perform better during low inflation.