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Stocks have been struggling for much of 2022, and inflation has shot to a 40-year high. But how exactly are the two related? Experts say that while inflation undeniably has an impact on the stock market, it's a lot more complicated than basic cause-and-effect.
There's no magic lever that automatically makes stock prices go down when inflation rises. Yet when the U.S. Bureau of Labor Statistics releases its consumer price index reports on the cost of goods and services, investors tend to react.
In many ways, however, investors may not be responding to inflation as much as to what they think the Federal Reserve will do because of inflation.
"The expectation of what the Fed is going to do down the road is essentially feeding into the current stock price," says Kairong Xiao, a financial economist and assistant professor of business at Columbia Business School.
When inflation is high, the central bank often hikes short-term interest rates to try to cool economic activity. Higher interest rates make it more expensive for consumers and businesses to borrow and spend money.
Right now, the Fed is trying to rein in high inflation. It hiked the benchmark interest rate by a half percentage point in May after increasing the rate by a quarter percentage point in April, and it outlined a plan to reduce its balance sheet.
But the market is worried the Fed may slow the economy too much and ultimately tip the economy into the recession, says David Lefkowitz, head of equities Americas at UBS Global Wealth Management. A recession is typically bad news for stock prices: people are more likely to lose jobs and spend less money, and corporate profits drop.
"The market is forward looking and concerned that, at some point, all the Fed rate hikes as well as the unwinding of the balance sheet ultimately will lead to some softness in the economy that is too much for the economy to handle," Lefkowitz adds.
Drop in demand for risky assets
Now, as interest rates rise, the demand for more risky, potentially high-yielding assets like stocks is going down, Xiao says. Cryptocurrency is another risky asset that has recently seen prices plummet.
Plus, when you buy a stock, you're banking on the company making money in the future. But if interest rates go up, expectations for how much money a company will make make in the future are lowered because it's more difficult for them to borrow money and grow.
As Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors, previously told Money, when experts are looking at valuations and discounting future cash flows back to a present value, the higher discount rate is going to lead to lower valuations. This is in part why tech stocks — which are expected to pay off further out in the future — are doing particularly poorly during the current market selloff.
Business earnings and investor behavior
While experts say the Fed's actions on inflation are having the biggest impact on the stock market, there are tons of factors at play.
The value of stocks and prices in the stock market depends on profitability of companies, says Nicholas Economides, professor of economics at the New York University Stern School of Business. "If you are expecting that profitability will be high, then stocks have a high price."
Some companies are feeling the squeeze from inflation. For example, Walmart recently reported that its profit in the first three months of the year dropped 25% from a year ago, and the company largely named higher costs as the reason. Plus, when costs are high, consumer spending on more discretionary items (think: cable TV) is crimped as they're are forced to divert more of their income to basic necessities like groceries and gas.
While that can hurt the revenues of some companies, others may benefit from a shift in consumer spending. The oil and natural gas sector is one example. A huge disruption in the distribution of oil and natural gas has led to higher prices, and that can help companies like Exxon Mobil, Economides says. Exxon Mobil's stock price has jumped over 50% this year.
If costs are high and consumers are cutting back on discretionary items to spend more on necessities, you might think they're also cutting back on investing. While that may be a factor, it's a much smaller reason than the aforementioned ones. Why? Wealthier families are more likely to invest in the stock market, and inflation tends to hit low- and middle-income households harder, Xiao says.
Another investing behavior we often to see is momentum trading. This is the idea that when the stock market is doing well, people invest more money — and vice versa.
"When the stock market starts to fall, they're going to try to cut their investments," Xiao says. "That will make the price drop even worse."
Is inflation all bad for the stock market?
Some inflation is actually not bad for the stock market, especially for the largest U.S. companies that have good pricing power, Lefkowitz says. (Pricing power refers to a company's ability to pass costs on to consumers without hurting demand.)
This is especially the case if prices are increasing because there are high levels of demand since that makes it easier for companies to pass costs on to consumers — which, for the most part, is what we're seeing, Lefkowitz says.
A recent analysis from The Leuthold Group actually found that when inflation is high, stocks perform well right after the inflation rate peaks.
Even if you're really worried about what inflation and the Fed's interest rate hike means for your investment portfolio, financial advisors often say it's best to stay the course, especially if you have a strong investment plan in place with a diversified portfolio.
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