5 ways inflation can hurt stocks

After this linked article was published, several people have asked how inflation can hurt stocks. After all, they say, inflation is nothing more than too much money for too little goods and services. Why shouldn’t inflation be Well for the stock market because all that extra money has to go somewhere, including the stocks of companies that generate more income because of inflated prices?

In the short term this might be true, but as individuals 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 more about five ways inflation can hurt stocks.

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# 1: force tough choices

Inflation does not reach the same amount all at once. For example, in the most recent Consumer Price Index released by the Bureau of Labor Statistics, energy-related inflation stood at 30%, while the headline inflation level was 6.2% less terrible.

While you can reduce your energy use a bit by lowering your thermostat, consolidating trips, and switching to energy-efficient lights, chances are you can’t make up for all of those higher costs. As a result, the massively higher energy costs you are likely facing mean you need to cut back elsewhere in order to afford things like heat your home, cook your food, and commute to work.

People who cut spending in one area of ​​their life due to inevitable inflation elsewhere are reducing the income of the businesses associated with these less essential products. This can harm the actions associated with these types of businesses.

N ° 2: More aggressive cost reduction actions

When businesses are faced with higher costs, they start to get aggressive with their cost cutting actions. This could include things like changing formulas to reduce entry and processing costs, downsizing to lower salary costs and benefits, or lengthening maintenance cycles to reduce downtime. .

Anyone or business whose job depended on the old way of doing things is at risk of having their income (or wages) reduced or eliminated as a result of these cost-cutting choices. There could be some winners if a company switches from one ingredient or supplier to another, but because the overall goal is to reduce costs, that always represents a smaller pot of money.

Companies with less income are unlikely to see their shares increase. Employees whose jobs are at risk are unlikely to aggressively inject new money into the stock market. People who lose their jobs are more likely to sell stocks than to buy them, which can cause stock prices to fall.

# 3: higher borrowing costs

If you are looking for something that you cannot pay cash for (like a house or potentially a car), you will borrow the money to complete the transaction. If inflation means that the price of this item is higher today than it was in the past, you will likely 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 (principal and interest) will be. It’s money that comes out of your pocket every month that can’t be used for other purposes. If interest rates rise (which they often do in response to inflation), future borrowing will become more expensive, and any existing adjustable rate loans will also see their costs increase.

Any money spent on debt service is money that cannot be invested in the stock market or spent on other goods and services. Whether it’s a lack of new investments or a lack of income, any of these factors can lead to challenges for stock prices.

# 4: an increased need to hold assets in other forms

Typically, the money you plan to spend out of your portfolio over the next five years does not belong to stocks. If you are a retiree who expects to spend $ 40,000 per year from your portfolio, that means you will need $ 200,000 in low risk investments, assuming there is no inflation.

Yet the elderly often face higher rates of inflation than the general population, mainly due to health care costs. So if general inflation stays at 6.2% and seniors face an additional 2% due to health care costs, these expenses will need to increase by 8.2% each year just to maintain their purchasing power. As a result, that $ 40,000 this year becomes $ 43,280 next year, and so on. All in all, that brings the $ 200,000 needed outside of inventory to just over $ 235,600.

This extra money has to come from somewhere. For a retiree living on a portfolio and Social Security, the money is likely to come from the sale of stocks to raise cash, CDs, equivalent-term treasury bills, or higher quality bonds.

# 5: Better risk-adjusted returns elsewhere

Low interest rates have helped support the stock market. It stands to reason that if rates rise in response to inflation, the stock market may be affected as money forced into stocks by lower rates may find better risk-adjusted returns elsewhere.

For a simple example of how this works, consider an investor who is trying to generate income from their portfolio. As of this writing, 30-year US Treasury bonds offer a miniscule interest rate of 1.69%. It’s pretty easy to find stocks that offer higher current dividend yields than this, and unlike a standard 30-year Treasury bond, stock dividends have the potential to rise over time.

Although this investor may want to The relative safety of a treasury bill, low rates practically force that investor’s money into higher risk stocks. If rates rise, investors in that position will have the option of shifting their money into bonds, thus removing the boost that stocks receive.

Inflation poses 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 a number of ways. Recognize these risks and do your best to prepare for them, and you can prepare for a temporary tough time caused even by these high levels of inflation.

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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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