How does inflation affect the stock market and potential strategies to take with your clients

Key Takeaways:
• Adjust your investment strategy with an eye on inflation
• Increasing oil and wheat prices from the war in Europe likely to exacerbate inflation pressures
• Low interest rates lead to negative real returns, net of inflation

Inflation has reared its ugly head. After a decade-plus stretch of modest price increases, the Consumer Price Index jumped 7% in 2021¹ . Early 2022 numbers suggest this trend may continue for a while. Inflation can be scary, but here are a few important points that can help you understand, and possibly plan for the impact of inflation on your retirement plans.

The stock market helps keep up with inflation and build wealth over the long term

First, keep in mind that inflation is why we invest. While you may feel caught off guard by the recent price surge, by investing in the stock market you’ve already been preparing for this very moment. From 1914 to 2022, US inflation has averaged 3.25% annually. The S&P 500® Index, on the other hand, has had an average annual return of 10.49% from 1926 through 2021² . By staying invested over the long term, you haven’t just been keeping up with inflation, you’ve been building wealth.

Also, be aware that economists have long studied the connection between inflation and stock market returns. While many have concluded that inflation has a net negative impact on the markets, there does not appear to be a clear correlation between inflation and market returns. Historically, periods of high inflation have seen both positive and negative stock market returns. Many factors contribute to stock market performance, and inflation is just one of them.

What does Russia’s attack on Ukraine mean for inflation

As a major energy producer, Russia’s spigot of oil and natural gas to global markets is likely now to be in limbo for the foreseeable future. Those reduced supplies are already impacting oil prices, raising the cost per barrel to levels not seen since 2008. Higher energy costs across the globe are certain to ripple through our economy at home, causing additional pain at the pump and leading to higher costs for businesses and the goods they produce. Additionally, Russia and Ukraine together produce around 1/3 of the global export of wheat³, so grocery prices already high over the past 12 months will only face added pressures upward. Still, while tensions in Europe may create near-term inflationary pressure and volatility, they should not disrupt your long-term investment strategy.

History says don’t panic about inflation

Investors should also remember that sustained periods of inflation are rare in US history. There has only been one instance of inflation exceeding 5% for 10 consecutive years (1973-82). While that was a very tough period in US economic history, there have only been seven instances of consecutive years of 5% inflation in US history (and two of those were in the 1800s). While extended periods of inflation can happen, they are infrequent.

Effect of inflation on the stock market

So, while we don’t want to panic in the face of inflation, we do want to acknowledge its impacts. As we’ve seen in recent months, a sudden spike in inflation can lead to market volatility. Stock prices, and stock market returns, are largely based on expectations of companies’ future earnings. As inflation erodes the value of a dollar of earnings, it can make it difficult for the market to gauge the current value of the companies that make up market indexes. Further, higher prices for materials, inventory, and labor can impact earnings as companies adjust. As a result, stock prices can fluctuate, and this causes volatility. When we experience significant volatility early in retirement, specifically negative market returns, it can impact the potential longevity of our retirement portfolios. This is sometimes referred to as a “sequence of returns” risk.

How does inflation impact cash and bond yields

Another reason we should be very mindful of inflation is because of what it means for cash and bonds. With interest rates still very low, and interest on savings accounts almost non-existent, inflation can quickly erode the value of cash positions. Similarly, fixed-income investments, such as bonds, can do poorly in periods of high inflation. One concept to be familiar with is “real returns.” This typically refers to the difference between the interest rate received by an investor and the rate of inflation. For example, if the interest paid by a 10-year treasury bond is 2%, but inflation is 7%, that implies a “real return” of -5%. This can cause the value of that bond to fall. In addition, to combat higher inflation, the Federal Reserve may implement policies designed to increase interest rates across the economy. Higher interest rates can also lead to lower prices for bonds, and even negative returns for bond mutual funds.

Inflation vs stock market graph

The good news is that while Fed tightening can negatively impact fixed-income investments, equities have often historically done well during these cycles.

_{Source: Standard and Poor’s}

_{Graph via: Nationwide Market Insights, Q1 2022}