What is inflation and why is it affecting the stock market?

Last Updated on 13 May 2021 by Dan

Hello everyone! At the date of writing (13th May 2021) the stock market is on the position of being in a fairly sharp decline over the week as concerns about inflation mount in the US.

As a result I thought I’d write a market commentary piece on inflation, covering why it’s a concern and some reasons on why it may be affecting stock market valuations.

As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.

What is inflation?

Inflation is where prices across the economy as a whole generally begin to rise. It’s usually the case that individual items only go up a little bit so it’s something you don’t massively notice, but taken all together it has quite an effect. Let’s say you’re buying some particularly luxurious yogurt and it costs you £1.50 – only you go in one day and find it’s £1.60 instead. When you get to the till you find your shop is £5 more expensive than it normally is. That’s inflation.

There are two types of inflation, but they can happen together:

Cost push inflation is where the raw materials needed to make products are going up in price, so the end product becomes more expensive.

Demand pull inflation is where retailers find they have limited supply but lots of people wanting their product, and can still sell effectively at a higher price.

How does inflation get measured?

There are a couple of methods of tracking inflation, but here in the UK it’s generally done through the CPI (Consumer Price Index). The Office of National Statistics undertakes surveys to find out what families are generally spending on a “basket of goods”.

This basket of goods is frequently updated to take account of trends and buying patterns over time – that causes a bit of distortion in itself but what people buy does change!

Why is inflation a concern?

When inflation rises, it’s usually a sign that the economy is essentially moving too quickly – prices continuing to go up is not good for the overall health of the economy.

There’s many reasons why, but to cover a couple:

  • Unless wages also rise, living standards are effectively declining as costs begin to rise but take-home pay doesn’t increase.
  • The effect of inflation can begin to snowball – because you know prices are going up you buy something now instead of later, causing prices to go up…. when this happens in extreme cases it’s called hyperinflation, and incredibly damaging to an economy.
  • Inflation itself creates undesirable costs and effort – retailers and manufactures have to put more effort into monitoring and adjusting prices.
  • It can cause capital flows between countries, as it suggests a decline in the real buying power of (let’s say dollar) in the country affected by the inflation which can affect the foreign exchange rate and attractiveness of trade.

What then stops inflation?

In the UK, the Bank of England has a responsibility to try and ensure economic stability. One element of this is to try and keep inflation reasonably consistent at a target rate of 2%. If it significantly exceeds this, the Government tends to intervene to stop inflation.

There’s a range of things a Government can do to try and curb inflation, but the most generally accepted tool is to raise interest rates.

The reason for this is that if you increase the cost of interest rates, the cost of borrowing money becomes more expensive (and the potential benefits from holding money increases though interest on savings).

So if borrowing is more expensive, you become less likely to spend…….

And if you’re less likely to spend, the immediate pressure on the economy drops away until inflation reaches a more manageable level.

Think of it a bit like a brake on a train – the economy doing well is getting you to your destination, but the speed is hitting the point passengers are getting nervous. So you just slow things down a bit.

Why is inflation affecting the stock market?

With the amount of financial stimulus that has been put into the US market to deal with the aftermath of COVID, there were already concerns that everyone spending might potentially drive inflation. Those fears became more concrete in reality this week when the US announced it’s official inflation figure for April – a historically high 4.2%.

Think about what been discussed above – if we’ve got inflation, we’ve probably got interest rate rises on the way. US Officials are denying that’s the case, but based on economic history, it becomes something of an expectation.

As a result the market is pricing in an expectation of interest rate rises – because as we’ve seen above, they slow spending – and ultimately company valuation is built on people spending their money!

Firms also tend to borrow to fund expansion and capital investment, so rising interest rates also make this less attractive.

The other factor driving the market element is that fact that the rate of inflation came as a shock, so markets are correcting. Inflation was expected to be a growing concern, but most official forecasts were at the rate of US inflation to be around the 2% mark, rather than the 4.2% it was.

As a result, the market corrects in price because it suggests an expectation those rate rises may arrive sooner than expected.

Should I change my stock holdings because of inflation?

It’s market blips like that that form part of the underpinning rationale of this site that you should always invest for the long term.

Markets historically have generally consistently appreciated in the long term, and history shows that selling off in such blips tends not to pay off – having said that, nothing is ever guaranteed!

Personally I’m not changing a thing and will wait it out – I still see a lot of positive in the economy as we return to normal and what has been “pent up demand” feeds back into markets. Some stocks seems expensive, but I think there’s also still value out there.

Where you might be affected is if you potentially have a need to withdraw money from your portfolio in the short term, should this be a longer trend.

It’s worth reviewing your portfolio if you feel you might be in this position, and speaking with a regulated and reputable financial adviser.

Any questions or thoughts?

Do you have further questions about inflation, or thoughts on the present market? Drop us a note in the comments below?

And that’s it!

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