How Does Inflation Impact Stocks And Bonds

Key Take-Aways

Low rates of inflation help an economy grow and promote business expansion, while high rates of inflation destroy wealth stored in cash and cash equivalents
When the rate of inflation is greater than expected, bond values are negatively impacted
The impact of inflation on stocks is mixed, though stocks generally outpace inflation and act as a good long-term store of wealth
Value stocks tend to outperform growth stocks during periods of high inflation, while growth stocks outperform value stocks during periods of low to negative inflation
Using M1 Finance , investors can easily create a portfolio using ETF’s such as VTV and VUG to create a balanced portfolio that does well during periods of low and high inflation

Note, stocks mentioned in this article are for illustrative purposes only, they are not recommendations to buy or sell any security. Please talk to your preferred financial advisor before taking any investment actions.

Investors are primarily concerned with finding investments that produce positive rates of return, however, what matters most is inflation-adjusted returns. History has shown that stocks generally outpace inflation, but the effects of inflation on stocks and bonds vary over time. For this reason, inflation is a key consideration for investors seeking to build long-term wealth.

What Is Inflation?

When we hear of inflation we often hear that inflation is simply the rise in prices for goods and services over time. And though this is not entirely wrong, it’s not entirely correct either. More precisely, inflation is the decline of a currency’s purchasing power over time, such that each $1 buys less and less goods and services over time. The end result is that it takes more dollars to buy the same goods, and thus we see higher prices.

The root causes of inflation are too many to name, however, the different factors fall into 1 of 2 broad categories known as cost-push inflation and demand-pull inflation.

Cost-push inflation occurs when the input costs for a good or service increase (ie higher labor, rent, or raw material costs) and the producer pushes some of those costs to the consumer in the form of higher prices. For example, an airline company raising ticket prices in response to a jump in jet fuel prices or a cereal maker increasing prices due to increased wheat prices.

Demand-pull inflation occurs when consumer demand for a product or service is so high that producers are forced to raise prices in order to keep up. As an example, prices within the housing market rise as individual buyers compete for a relatively fixed supply of housing (perhaps as a result of cheap debt?).

Is Inflation Good Or Bad?

With a firm understanding of what inflation is and what causes it, it seems reasonable then to assume that any inflation is a bad thing, right? After all, who wants the value of their money to decrease, and who wants to pay more for the same goods and services? Well as it turns out a little bit of inflation is actually a good thing.

Now to be clear, too much inflation—such as that seen in post World War 1 Germany, or hyperinflation as seen in Zimbabwe in 2007 and, more recently, in Venezuela in 2018—is a very bad thing as it erodes an entire nations’ wealth and destroys the economy. However, mild inflation of 1% to 3% annually is actually a good thing as it incentives firms and individuals to invest and spend money rather than store it at the bank, and it forces companies to increase productivity—those that do not, end up a thing of the past. For this reason, central banks across the world target inflation rates within the range of 1% to 3% annually. When inflation is too high, central banks will increase interest rates or undertake other financial tightening measures to cool the economy and tame inflation.

But Aren’t Lower Prices Better?

If you’re still not convinced that mild inflation is a good thing and believe that declining prices are better (ie deflation or a strengthening dollar), follow this thought experiment. When you go to the grocery store, how often do you hold back on buying something because you know the price will come back down or a sale is right around the corner? Now take this one step further, what if you knew that the price of most things would be lower next month, and then even lower 6-months and 12-months from now. Most rational people would hold back on a purchase as long as they could. This decrease in purchases means a decrease in spending, and one person’s spending is another person’s paycheck. So by spending less, someone somewhere is getting paid less or out of a job entirely. Additionally, with sales slumping, companies would cut back on hiring, raises, and investing in new factories, which itself ripples through the economy and creates a second and tertiary wave of cutbacks. This negative feedback loop continues, decimating an economy. Sounds pretty bad right? That’s why governments across the world always target mild inflation and do everything in their power to avoid a general decline in prices.

How Does Inflation Impact Investments?

The impact of inflation on cash is pretty clear, inflation is a silent killer of wealth stored in cash and cash equivalents (checking, savings, and even CD accounts). On the other hand, the impact of inflation on investable assets is not always clear, and it depends greatly on the nature of inflation and the asset class itself as not all assets will produce returns in excess of inflation. That said, even if an asset’s returns do not compensate for the erosion of wealth via inflation, the return of an asset can help mitigate the damage.

The Effect Of Inflation On Bonds

Before analyzing the effect of inflation on stocks, let start first with the impact of inflation on bonds as it is easier to understand and provide insights to use later when analyzing stocks. Bonds are fixed-income investments where you lend out money today and get paid back a fixed amount in the future. Since inflation weakens the purchasing power of a currency, with bonds you lend today and get paid back tomorrow with weaker dollars. Most bond investors are aware of this issue, and incorporate the rate of expected inflation into the yield they demand on their investment; however, there is always the risk that inflation outpaces the yield of a bond and this is one of the primary risks associated with investing in bonds (the other being default risk and interest rate risk).

As a concrete example, take a bond yielding 3% with 1-year until maturity. If you invest $1,000 today, you can expect to receive $1,030 a year from today, making a pre-tax profit of $30. All seems well, but we have ignored inflation. If economic trends persist as normal, inflation will be about 2% over the investment period and the inflation-adjusted rate of return of the above-listed bond will be 1%—yield on the bond minus the rate of inflation. If, however, inflation is more than expected and hits 5%, then the real rate of return of the bond would be -2%. This does not mean that you were paid back less than anticipated, but instead, the purchasing power of the currency declined more than anticipated. At the end of the 1-year period, you got back the $1,030 as promised, however, the purchasing power of that money declined more than initially anticipated. To be clear, having your money invested in the bond helped mitigate the negative impact of inflation, and sometimes that is the best an investor can do.

Also important to note, that unanticipated levels of inflation not only devalue the currency that the bond is paid back in, but it also increases interest rate risk. As mentioned earlier, when inflation is too strong, Central Banks will increase interest rates, and that will decrease the value of any existing bonds by increasing the discount rate and decreasing the present value of the future cash flows. Intuitively, if you bought a bond yielding 3%, but new bonds issued after your purchase yield 4%, who would buy your bond? The answer is no one unless you are willing to lower the price of the bond to increase the effective yield.

The Effect Of Inflation On Stocks

From January 1, 1981, to December 31, 2020, U.S. stocks, as measured by the S&P 500, grew at an annualized rate of 9.3%, before inflation. After adjusting for inflation, the annualized returns of the S&P 500 from 1981 to 2020 totaled 7.1%—lower, but still outpacing inflation. From this high-level overview, we see that in general stocks not only help preserve wealth but grow it over time; however, these high-level figures mask some of the unequal impact of inflation on different areas of the stock market. A broad basket of stocks can be easily created using ETFs like VTI using brokers such as M1 Finance.

Inflation Impact On Value Stocks VS Growth Stocks

In addition to categorizing stocks based on size, stocks are often divided based on some fundamental characteristics—the most notable being valuation. Broadly speaking, value stocks are those whose prices are low relative to some fundamental metric such as earnings, sales, or dividends. Conversely, a growth stock is one whose price is high relative to some fundamental metric. This is an oversimplification, but it gives us a working definition to then compare the impact of inflation on value stocks (low P/E, P/S, etc.) and growth stocks (high P/E, P/S, etc.).

With our simplified definition of value and growth stocks, we can say broadly that for value stocks we are paying for current stable cashflows, while for growth stocks we are buying large future and uncertain cash flows. Given the nature of inflation and monetary policy in place to moderate it, we would expect inflation to negatively impact growth stocks more than value stocks since dollars for growth stocks are in the far future, while dollars for value stocks are current.

The below chart, created by Evidence Investor, plots the annualized return differential between value stocks and growth stocks during different decades against the annualized rate of inflation for that decade. From the chart, we can see that in general value stocks tend to outperform growth stocks during periods of high inflation while growth stocks outperform during periods of low to negative inflation. As an example, looking at the 1970’s data point we can see inflation was roughly 8% annualized for that decade, and over the same timeframe, value stocks outperformed growth stocks roughly 10% a year. Alternatively, when inflation was negative, ie deflationary period, value stocks severely underperformed growth stocks.

Why Does High Inflation Hurt Growth Stocks

With growth stocks, current cash flow is either low or non-existent and as a result investment payback is at a distant future. Those future dollars have to then be discounted to today’s dollars at some discount rate R. This discount rate, incorporates both interest rates and expected inflation rates over the lifetime of the investment. All things equal, a higher discount rate will decrease the present value of future dollars just as we saw with bonds.

Discount rates, present value? It may seem complicated, but follow this example to hopefully get a better understanding. Imagine a scenario where I sell you an IOU for $100 to be paid in full tomorrow—assume 100% guaranteed. Many would likely be confused, but willing to pay $100 today for $100 tomorrow. Seems pointless, but now let’s say instead of 1-day I said 1-year from now. How much would you be willing to pay today to get $100 1-year from today? If you said something like $90, then that means your personal discount rate, or required rate of return, is roughly 11.1%. $90 invested for 1-year, with a rate of return of 11.1%, grows to $100. Now if I told you inflation over the next year was going to be 10%, would you still be willing to pay me $90 today for $100 a year from now? Most rational investors would adjust and would only offer to pay about $82.50 today for a $100 payout a year from today. The rate of return that grows from $82.50 to $100 in 1-year is roughly 21%, and after adjusting inflation of 10%, the final return is again roughly 11%. As we can see, the higher the expected inflation rate, the less we are willing to pay today for dollars tomorrow as we require a higher discount rate. This means the present value of an investment will decline as inflation rises.

How Does Inflation Affect Value Stocks

That was a lot, but hopefully, after that example, it is now clear how high inflation negatively impacts growth stocks whose payout is far into the future. Now turning to value stocks where the opposite situation plays out since by definition we are paying for current cash flows rather than fast-growing future cashflows. Additionally, many times, though not always, stable value stocks pay a dividend, and thus the cash return will start as soon as the next quarterly payment instead of some uncertain date in the far future. Since the cash flows are in the present, the negative impact of inflation is less for value stocks than it is for growth stocks and liquidity will typically flow towards value vs growth stocks when investors are anticipating elevated levels of inflation.

It is important to note, that for value stocks we are assuming that cashflow trends are stable to slightly positive. If cash flow is declining, then inflation will be even worse for such stocks than for growth stocks; so be wary of value traps.

Conclusion

Although inflation is typically seen as bad, we have seen that low levels of inflation help support long-term economic growth. That said, periods of high levels of inflation are detrimental to bond investors, while the impact of inflation on stocks is mixed. Broadly speaking, a broad basket of stocks helps protect and grow an investor’s wealth as stocks tend to outpace inflation. However, digging a little deeper, data has shown that inflation negatively impacts growth stocks versus value stocks. As a result, during periods of high sustained inflation, value stocks will outperform growth stocks, while during periods of low inflation, growth stocks will outperform value stocks. Using a platform such as M1 Finance, you can easily create a broadly diversified portfolio of growth and value stocks using ETF’s such as VUG (Vanguard Growth) and VTV (Vanguard Value).

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