Here’s how inflation affects stocks: 5 things you need to know

While the inflation rate is lower than it was in mid-2022, the rate is still pretty high overall. Since inflation has been an ongoing issue, many people are increasingly wondering, “How does inflation affect stocks?” Ultimately, inflation can impact the stock market in many ways. Here are five things you need to know about how inflation impacts stocks.

1. Broad inflation impacts nearly any stock

While most reports about inflation focus on a single figure based on average price changes of products and services listed in the Consumer Price Index (CPI), it doesn’t show the disparities between the various product and service categories. Some consumer categories may see double-digit inflation, while others may see minor changes or even declines.

The trick is that broad inflation has an impact on practically every stock. When consumer prices are rising in many core categories – such as groceries, utilities and gasoline — it significantly impacts household budgets. This can lead to a widescale spending decline, potentially affecting the bottom line of any consumer-oriented business, particularly those deemed non-essential. Essentially, those companies are seeing falling revenues, and when revenues decline, stock prices usually suffer.

However, even companies selling essential consumer goods and services aren’t shielded from stock market declines. Rising prices can mean that consumers scale back, looking for ways to save on their essentials. Again, this can lead to diminishing revenue even if consumer prices are rising, which drives stock prices down.

Additionally, all companies are seeing their costs rise. Inflation also impacts the price of materials they require for producing the products they sell. Since their costs are going up, profits can fall, which is something else that lowers the stock price.

2. Rising inflation reduces access to money

When inflation goes up, a common path for countering it is increases to interest rates by the Federal Reserve. While this doesn't seem like it would impact stocks, it actually does. Higher interest rates — and the stricter borrowing requirements that come with it — limit businesses from getting credit. That can hinder a variety of activities, including developing new products, expanding facilities, replacing aging equipment, and more.

As a result, companies can become relatively cash-strapped, preventing them from pursuing actions they would if funding were more accessible and affordable. In some cases, the ramification of waiting is lower stock prices.

3. Inflation triggers market volatility

Market volatility often accompanies inflation. Along with issues like those above leading to quickly shifting prices, inflation also influences investor sentiment. Those with established portfolios may see the total value of their investments decline, causing them to make reactive investment choices. They may sell for fear of losing more value or might avoid investing more since they’re worried the investment will continue declining after purchase.

Investors with less income may also scale back from investing, particularly if they’re otherwise struggling to make ends meet when prices rise. Again, this is a change in broader investor behavior, and it can lead to more volatility.

Individuals getting close to retirement may also move their investments quickly during inflation. Often, it’s a means of preserving as much of their portfolio value as possible, something that’s more necessary if you’re planning on tapping those funds in the near future. They may also need to withdraw more than originally anticipated to cover their rising expenses, leading to more money withdrawing from the market than would otherwise.

4. Rising interest rates make stocks less appealing

During periods when interest rates are low, stocks end up more appealing. Often, that’s because getting returns anywhere near what the stock market offers through safer options like high-yield savings accounts or Treasury bonds isn’t possible. If growth is the goal, stocks seem like the only option.

When interest rates rise, returns on lower-risk options usually go up while stock market returns decline. As a result, transitioning funds to Treasury bonds or high-yield savings accounts could actually lead to more growth until the situation stabilizes, which can potentially negatively impact the broader market.

5. Inflation could create opportunities for bargains in the stock market

One benefit of lower stock prices is that it could lead to opportunities for some bargains in the stock market. Long-term investors could pick up shares below the price they’ve seen in the period leading up to the high levels of inflation. Then, if the economy recovers, the values of those stocks usually rise, leading to potentially solid returns.

Ultimately, there is risk in using this approach. It isn’t clear how long inflation will remain an issue or how high interest rates will go. Additionally, some companies may fail to weather the current storm, causing them to lose value and not recover. However, businesses with a history of stability, even during challenging times, are worth exploring.

Just make sure to research any investment thoroughly when volatility in the market and uncertain economic conditions are part of the equation. That ensures investors can find opportunities with risk levels they’re comfortable with, and that makes a difference.

This article was written by Tamila McDonald from Saving Advice and was legally licensed through the DiveMarketplace by Industry Dive. Please direct all licensing questions to legal@industrydive.com.