This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
After this linked article was published, several people asked how inflation could hurt stocks. After all, the argument goes, inflation is nothing more than too much money chasing too few goods and services. Why wouldn't inflation be good for the stock market as all that extra money has to go somewhere -- including into the stocks of companies bringing in more revenue due to inflated prices?
In the short term, that might be true, but as people and businesses are forced to adjust to the higher and rising prices that inflation brings, the longer term reality can get downright ugly. Read on to learn about five ways that inflation can hurt stocks.
No. 1: Forcing tough choices
Inflation doesn't hit everywhere the same amount all at once. For instance, in the most recent Consumer Price Index published by the Bureau of Labor Statistics, energy-related inflation ran at 30%, while the overall inflation level clocked in at a less awful 6.2%.
While you might be able to reduce energy use a bit by turning down your thermostat, consolidating trips, and switching to energy-efficient lights, chances are you can't offset all those higher costs. As a result, the massively higher energy costs you're probably facing mean that you have to cut back elsewhere in order to afford to do things like heat your home, cook your food, and get to work.
People cutting back spending in one area of their life due to unavoidable inflation elsewhere reduces revenue for those companies associated with those less-immediately essential products. That can hurt the stocks associated with those types of companies.
No. 2: More aggressive cost-cutting actions
When companies are faced with higher costs, they start getting aggressive with their cost-cutting actions. That could include things like changing formulas to reduce input and processing costs, reducing staff to cut salary and benefit costs, or stretching out maintenance cycles to reduce downtimes.
Any person or company whose job depended on the old way of doing things is at risk of reduced or eliminated revenue (or salaries) from those cost cutting choices. There might be some winners if a company switches from one ingredient or supplier to another, but since the overall goal is cutting costs, it still represents an overall smaller pot of cash.
Companies with less revenues are not likely to see their stocks rise. Employees whose jobs are at risk are not likely to be aggressively pouring new money into the stock market. People who lose their jobs are more likely to be selling stock than buying it -- all of which can add up to lower stock prices.
No. 3: Higher borrowing costs
If you're in the market for something that you can't pay cash for (such as a house or potentially a car), you will borrow money to complete the transaction. If inflation means the price of that item is higher today than it was in the past, you will likely both pay more and borrow more for that item.
Even if interest rates stay the same, the more you borrow, the higher your debt service costs -- both principal and interest -- will be. That's money that comes out of your pocket every month that can't be put toward other uses. If interest rates rise (which they often do in response to inflation), then future borrowing will become more expensive and any existing adjustable rate loans will also see costs increase.
Any money spent on debt service costs is money that can't be invested in the stock market or spent on other goods and services. Whether from lack of new investments or lack of revenues, either one of those factors can cause challenges for stock prices.
No. 4: A greater need to hold assets in other forms
As a general rule, money you expect to spend from your portfolio within in the next five years does not belong in stocks. If you're a retiree who expects to spend $40,000 per year from your portfolio, that means you'll need $200,000 in lower-risk investments, assuming no inflation.
Yet seniors often face higher inflation rates than the general population, driven largely by healthcare costs. So if general inflation remains at 6.2% and seniors face an extra 2% due to healthcare costs, that spending will have to increase by a whopping 8.2% each year just to maintain its purchasing power. As a result, that $40,000 this year becomes $43,280 next year, etc. Overall, that balloons the $200,000 needed outside of stocks to a bit more than $235,600.
That additional money has to come from somewhere. For a retiree living off a portfolio and Social Security, chances are that the money will come from selling stocks to raise cash, CDs, or duration-matched Treasuries or investment-grade bonds.
No. 5: Better risk-adjusted returns elsewhere
Low interest rates have helped bolster the stock market. It stands to reason that if rates rise in response to inflation, the stock market can get hurt as the money forced into stocks by lower rates can find better risk-adjusted returns elsewhere.
For a simple example of how this works, consider an investor who is trying to generate income from his or her portfolio. As of this writing, 30-year U.S. Treasury bonds offer a minuscule 1.69% interest rate. It is fairly easy to find stocks that offer higher current dividend yields than that, and unlike a standard 30-year Treasury bond, stock dividends have the opportunity to increase over time.
While that investor might want the relative safety of a Treasury bond, the low rates are practically forcing that investor's money into higher-risk stocks. If rates rise, investors in that position will have the ability to move their money into bonds, thus removing the boost stocks are getting.
Inflation presents real risks to your finances
Between the immediate risks to your purchasing power and the longer term risks to things like your job and your stocks, inflation can hurt your overall financial position in multiple ways. Recognize those risks and do your best to prepare for them, and you can set yourself up to make it through a temporary rough patch caused by even these elevated levels of inflation.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
