As the Federal Reserve continues to artificially suppress interest rates to record lows, many investors are wondering how that will impact inflation and stocks. Inflation is simply the rise in the price of goods and services which reduces our purchasing power.
Although simple, inflation can seriously hurt our economy. Unexpected inflation can do even further harm to the economy and the savings of people. If prices rise, consumers purchase fewer goods and services, company profits decline, and economic growth contracts. But what impact does inflation have on stock prices?
- High levels of inflation have a negative impact on stock prices and the overall economy
- Oils, metals, and emerging markets tend to do well during periods of higher inflation
- Stocks that have strong cash flows, price control, and market dominance do well during periods of high inflation
The Impact of Inflation on Stocks
Higher levels of inflation have an overall negative impact on stock prices. It increases the cost of borrowing, labor, materials and can reduce the overall standard of living. This in turn reduces growth for public companies and pushes stock prices down.
An unexpected rise in inflation is considered very harmful to the economy. COVID has disrupted supply chains, the supply of labor, and pushed rates to remain low for longer than expected. All of these factors combined have caused the rate of inflation to spike.
As we can see from the chart, there has been a massive spike in the consumer price index between November 2019 to November 2021. It’s also the highest it has been in the past 20 years.
The extended low-interest rate environment combined with the ripple effect of COVID 19 has created a massive spike in inflation in a very short period of time. The massive stimulus distributed to individuals during the pandemic has also helped to fuel the spike in inflation.
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However, the stock market continues to rip up higher confusing many investors. Inflation is impacting the economy and stock prices, but not at the same pace. Investors are talking about the inevitable stock market crash that must happen for our economy to make sense. But will that happen and what kind of stocks should you invest in as a hedge against inflation if it continues to increase through 2022.
Inflation and Interest Rates
The Federal Reserve makes monetary decisions in the U.S. and sets the federal funds rate which influences the rates banks charge consumers. Interest rates are usually increased to battle inflation. Interest rates and inflation are inversely correlated to one another. Generally, when interest rates are held low, the economy grows and inflation tends to rise. It’s also good to be aware of the differences between inflation and deflation.
The current problem that we have is that the Federal Reserve has held interest rates to record lows for an extended period of time (see graph above). Add on the impact of COVID-19 to the economy along with additional stimulus and you have unexpected levels of inflation. One thing is for certain, the Fed has to increase interest rates or the economy and the stock market will experience serious consequences.
Types of Stocks and Assets that Benefit During Inflation
In order to prepare for higher level for inflation it’s important to diversify your investments into stocks and asset classes that benefit from inflation. Companies that have pricing power and stable cash flows are preferred stocks to invest in when inflation creeps up.
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Inflation is also generally bullish for oil, metals and emerging markets. Most bond holdings tend to be negatively impacted during periods of inflation. According to a study done by Wells Fargo, the price of oil has gone up over 40% during inflationary periods since 1995. This can be seen in the United States Oil Fund (USO), an ETF that tracks the price of oil. It’s currently up over 59% in 2021.
Best Stocks for Inflation
Individual stocks that tend to do well during periods of inflation are ones that dominate their market, have strong positive cash flows, and have strong pricing power. Below are our 3 best stocks for inflation.
Nvidia designs and manufactures computer graphics processors and computer technology. They are uniquely positioned to be the main supplier of computer graphics for the Metaverse. They have a strong balance sheet and their computing and networking revenue grew over 100% in 2021. Nvidia is strongly positioned in the AI and virtual reality space and also doesn’t have many competitors at their scale and price.
Apple is one of the biggest companies in the world by market cap. They absolutely dominate the cell phone market and have recently announced plans to make their own electric car and also plans to get involved in the cryptocurrency space. They literally print money and have had consistent growth every single year since the company went public.
Adobe is a stock like no other. They absolutely dominate the graphic design and creative space. There is no other public company in the marketplace at their scale, pricing point, and market dominance. In 2019 they changed their software billing model to monthly recurring billing for all their software products instead of buying them outright. This shift has expanded their customer base and massively improved their margins.
The Bottom Line
Don’t let the fear of inflation cause you to liquidate your stock holdings and simply hold cash. Although the possibility of further inflation in 2022 is high, it doesn’t mean that you won’t make money in the stock market. Explore companies that have strong earnings and dominate their markets. Research emerging markets and find stocks that most people tend to overlook.