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How does inflation affect stocks?

There probably was a time you didn't think much about inflation. Now it's hard to not think about it. It seems like everything is more expensive these days, from airplane tickets to used cars to the snacks your family craves.

In these uncertain economic times, you may worry about the health of your finances. And you're not alone. According to Thrivent's 2022 Consumer Financial Outlook Survey*, 63% of people said inflation is pushing them off track financially. It's a natural reaction to be concerned about how inflation may impact stocks, and it is likely top-of-mind if you're currently invested in the market or are considering jumping in. Read on to learn why the answer isn't so simple and why stocks could be useful to own when the rate of inflation is soaring.

What causes inflation?

Inflation occurs when there's an imbalance of supply and demand for goods and services. When total demand for those goods and services exceeds total supply, prices tend to rise. They tend to drop when the opposite happens.

Inflation was relatively low in the U.S. economy for three decades. But in 2022, we've experienced the highest inflation increases in over 40 years.

> Read more about how inflation works & what causes it.

63% of people surveyed said inflation is pushing them off track financially.
2022 Thrivent Consumer Financial Outlook Survey

What does inflation do to the stock market?

Rising costs and uncertain revenue growth can take a toll on corporate profit margins, and stock prices can fall in response. On a broader scale, high inflation creates unknowns about future interest rates, and that uncertainty often contributes to market volatility.

Ultimately, it's tough to definitively say how inflation impacts stock market returns; inflation is just one of many variables at play. The repercussions of the COVID-19 pandemic are still weighing on the market, for instance, and so is global economic uncertainty created by Russia's war in Ukraine. Amid persistent inflation, the stock market experienced plenty of market volatility in 2022.

One way inflation comes into consideration is the correlation it has with the Fed's interest rate hikes—and expectations about the timing and size of future hikes. Higher interest rates can discourage businesses from borrowing money to expand operations, for instance. Fears about the economy dipping into a recession play a major role as well.

Why this could be a good time to invest in stocks

Yes, the stock market's ups and downs can be difficult to stomach, but holding equities actually could be beneficial for you right now for a couple of reasons.

For one, stocks are considered to be a hedge against soaring prices. They could help you equal or outpace the average rate of inflation over the long term. In fact, though you may not have thought much about it, stocks have been hard at work doing this for investors for quite some time.

Think about it: The S&P 500, an index that represents the average performance of a group of 500 large capitalization stocks, has gained about 10.7% on average annually since 1957. Yet, the inflation rate in the U.S. averaged 3.28% from 1914 to 2022.

Also, since sharp rebounds often follow periods of decline, you could be well rewarded for staying strong with stocks. Following the 10 bear markets (declines of 20% or more) since 1950, the first three months after the bottom saw returns bounce back 20.9%, on average, while the first full year climbed, on average, 43.4%. Those kinds of bounces are worth waiting for.

Growth vs value stocks: What you should know

Notably, some stock styles shine brighter in an inflationary environment than others. One reason has to do with that connection between inflation and rising interest rates. When interest rates are high, value stocks tend to perform better than growth stocks.

How growth stocks work

Growth stocks are typically companies whose shares are expected to grow at a faster rate than the market average. There are a few considerations to keep in mind about this type of investment:

  • Growth stocks attract investors who are willing to pay a higher price now because they have big hopes for the company's future growth and the payoff they may get when they sell their shares.
  • However, these stocks do not typically pay dividends, meaning being a shareholder wouldn't offer you a means of regular income from your investment.
  • Growth stocks generally have a large presence in their industry. Tesla is one example of a growth stock—it dominates the electric car industry and is expected to continue to outperform the market average.

How value stocks work

Value stocks, on the other hand, tend to be cheaper—they are companies that have a low price-to-earnings (P/E) ratio, which compares a company's current share price to its earnings per share. Here's what to know about value stocks as an investor:

  • Value stocks have a low P/E ratio, which might seem like a bad sign, but it could mean that a company's stock is undervalued. A low P/E is not always an indication of poor company performance.
  • When considering value stocks, it's important to look at the company's fundamentals—earnings, sales, dividends, etc.—to match the lower priced shares against actual performance. This will give you an idea of whether an undervaluation is the cause for the share price.
  • Value stocks often pay out dividends and generally lead to higher returns over the long-term.
  • Many value stocks belong to mature but steadily growing companies with stable revenues and earnings, with Berkshire Hathaway being one example.

What could happen to value stocks as rates rise?

The growth style has generally outperformed value over the past decade. While the Pure Growth index earned a 13.05% 10-year annualized return through late August 2022, the Pure Value index returned 9.79%.

Inflation and interest rates have introduced a plot twist. As of late August 2022, the value index has a one-year return of 2.85% while its growth counterpart has a dismal -18.35% return.

Value investing can be a smart strategy in a high-inflation, high-interest-rate environment. Though all investments have risk, buying undervalued stocks of companies with strong business fundamentals can be less risky and costly than buying growth stocks. High interest rates can negatively impact the above-average growth of those companies that investors are banking on.

However, there's not always a clear cut line of which stocks belong in which category. The internet is full of opinions about where Apple falls, for instance.

Likewise, it's become hard to assign sectors to one style or the other. Consider the S&P 500 Pure Growth index and the S&P 500 Pure Value index. Each contains S&P 500 equities that the index creators deem to exhibit the strongest characteristics of growth or value. In August 2022, you could find financial, health care and energy companies in both indices.

Factoring inflation into a stock's rate of return

With inflation so prominently in the picture, it's important to understand the difference between a nominal rate of return and a real rate of return.

A stock's nominal rate of return is the net gain or loss over a time period before adjusting for factors like inflation and taxes. While it can help you compare the performance of various stocks, it doesn't provide the whole picture you need to properly evaluate an investment.

A stock's real rate of return accounts for factors like inflation and taxes. The real rate of return is lower than the nominal rate of return when inflation is present.

Here's an illustrative example that uses simple calculations and ignores taxes and other factors: A stock that generates a 9% return over one year has a 9% nominal rate of return. However, when the inflation rate is 5%, the real return rate is only 4% (9% minus 5%).

Tips for investing in the stock market during periods of inflation

While it may not be the most fun time to be an investor, high inflation doesn't need to throw your financial goals off course. Here are some tips to consider:

Steer clear of emotional decisions

Watching your account values fluctuate greatly is certain to cause some financial anxiety. Don't make the mistake of exiting the stock market out of panic. You could end up missing out on gains when markets rebound. A buy-and-hold strategy can pay off for you over the long term.

Get strategic about your investment strategy

Consider a dollar-cost averaging strategy to take some of the emotion out of investing. You won't continually second-guess yourself if you set up a way to automatically deposit a fixed amount of money into a stock every week or every month. Plus, the strategy can help reduce the effects of volatility because you'll purchase more shares when prices are low and fewer shares when prices are high.

On that note, remember that a slumping stock market can provide an opportunity to find good stocks that are essentially on sale. (Who doesn't like a sale?)

Diversify & rebalance your portfolio

As in times of low inflation, it's wise to build and maintain a well-diversified portfolio.** While value stocks typically show strength during periods of inflation, it could be risky to limit all your holdings to those equities. Growth stocks likely will rebound one day. Aim for a mix of assets that fit your risk tolerance and account for the amount of time you plan to stay invested.

Your investment portfolio isn't set and forget. Be sure to review how your investments are working for you with a financial advisor. If your original target allocations of stocks, bonds and cash have shifted in a way that no longer match your risk tolerance and investment objectives, it may be time to rebalance.

Don't make investment decisions alone

Clearly, inflation can add head-spinning complexity to investment decisions that can be hard to navigate in the best of times. Think about connecting with a financial advisor to gain personalized insights and guidance around helping to protect your stock market investments from inflation during this volatile time.

*Methodology: This general population research was conducted in partnership with data intelligence company Morning Consult and polled 2,221 adults across the country between May 9 and 17, 2022. The interviews were conducted online, and the data were weighted to approximate a target sample of nationally representative adults based on age, gender, ethnicity, income, geography. Results from the full survey have a margin of error of +/- 2 percentage points.

While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.