Recently, growing inflation rates have rattled equities in the U.S markets. Experts say that investors need to account for some volatility in the market given that the economy is roaring back from its unprecedented stop due to COVID-19. Wall Street, the Federal Reserve, and companies in every sector are always closely watching inflation levels due to their impact on the stock market.

On May 12, the inflation rate reached 4.2%, which shocked the market and caused major indexes to fall. 

But first... 

What is inflation? 

Inflation is a general rise in the price of goods and services  over a period of time. High inflation increases the price of these things and therefore reduces individuals and companies' purchasing power.  

What does inflation mean for stock returns? 

Rising inflation has a gradual negative impact on stocks. The rise in inflation  results in higher input prices (costs associated with creating a product or service), meaning people can purchase fewer goods and costs rise for companies. A company's revenues and profits also fall, which in turn causes the economy to slow down. During a slow economy, fewer people have disposable income to buy stocks and more investors will sell their shares if they need more money. 

The rise in inflation affects companies because it takes them a few quarters to be able to pass higher input costs on to their customers, as they cannot just suddenly raise their prices out of nowhere. When they do raise their prices, consumers are forced to pay more than normal for goods and services. 

Oftentimes high inflation can reduce company's products, due to higher input costs, which causes companies to limit hiring and expanding. This means that stocks can be affected because if the business is not growing, then neither is its share price. 

Most studies say that expected inflation can either positively or negatively impact stocks, depending on your ability to hedge (reduce risk) and the government's current monetary policy.

With unexpected inflation, there is a strong positive connection between higher stock returns and times of economic decline as new information about future stock prices is available. In addition, more volatility in the market is associated with higher inflation rates too. 

If we examine the S&P 500 (NYSEARCA: VOO) returns, the findings prove that the highest returns occur when inflation sits between 2% to 3%. If rates are higher than this, it usually means there are larger issues occurring in the economy, like the current pandemic,  which has different impacts on the stock market. 

How does inflation affect growth and value stocks? 

Value stocks have strong cash flows that gradually slow, whereas growth stocks don't have a lot of cash now but are expected to in the future. When inflation rises, interest rates on borrowed money are also likely to increase, which impacts companies borrowing power and eats into profits. As growth stocks need to borrow money to expand their business, in times of high inflation, these companies are hit the hardest. 

How does inflation affect stocks that pay dividends? 

Dividends do not usually keep up with inflation levels which makes these stocks less attractive. Tax on dividends is another point to consider because they also rise where there is high interest rates. However, buying these income-generating stocks at times of high inflation is a good idea because it provides attractive buying entry points.  

What should investors do in times of inflation?

Investors should remember that stocks provide a hedge against inflation as business revenues should increase over time at around the same rate as inflation. 

The topic of inflation can be confusing for investors as it seems to affect both the economy and stock prices but at different times. Therefore, investors need to push past this confusion and remember that investing in quality, long-term businesses, will always prevail. 

Read more related articles below: 

Will Interest Rates Collapse The Market?

Investors Should Not Panic Sell Big Tech Stocks Following A Dip

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