Understanding Inflation and Its Impact on the Stock Market

If you have bought a car recently or even eggs it is evident that the prices of many goods and services are rising quickly. When prices rise generally the purchasing value of your money decreases, that’s inflation. How long will inflation persist? What impact will it have on your investments? What is the Federal Reserve doing to combat high prices? The answers to these questions can be rather complex and require an understanding of several moving pieces. 

In May, the Consumer Price Index (CPI) rose 4% year-on-year below the average economists’ expectation of 4.1% and its lowest increase since March 2021. Core CPI rose 5.3% year-on-year above the average economists’ expectation of 5.2%. Core CPI does not include prices from the volatile food and energy sectors, it is often considered a more accurate gauge of the true level of inflation. 

Lower than expected inflation is generally bullish for US bonds whose prices rallied and yields declined following the release of the data. If inflation is cooling faster than expected that means the Federal Reserve is likely to slow its pace of rate increases and eventually look to cut rates as inflation returns to the Fed’s two percent target. 

It is important to note that while the rate of inflation is decreasing, it is still positive. This is known as “disinflation.” “Deflation” on the other hand is when inflation grows at a rate less than zero. Deflation can be just as dangerous as rapidly increasing inflation as consumers may delay purchases in hopes that goods and services will be cheaper in the future. This can lead to a decrease in overall economic growth. 

Following an initial drop after the release of the data, on the morning of June 13, bond yields quickly reversed higher as traders digested the entire report, which include a higher-than-expected core CPI number, an indication that many professional traders are unclear about where inflation is headed. 

Stocks have a complicated relationship with inflation. Generally, stocks should rise along with prices as companies are able to pass their increased costs along to consumers. That means higher inflation should lead to higher stock prices, at least in nominal terms. That is not always the case though as when companies raise their prices consumers may not buy as many items as they previously had or may substitute less expensive items for high-priced ones. This can weigh on companies’ profits, which in turn can affect their stock’s valuation. 

Additionally, investors must consider the actions of the Federal Reserve. Part of the Fed’s mandate is to ensure price stability. When prices rise too fast consumers have less purchasing power which can impact their quality of life, lower their ability to save and make it harder for them to budget. To combat rising prices the Fed will increase short-term interest rates. As it becomes harder and more expensive to borrow money consumers will spend less. That decrease in demand will eventually halt the rapid rise in the prices of goods and services. This sometimes can lead to a recession which can be a negative for stocks. 

Higher interest rates can also raise the desirability of fixed income investments relative to equities. If investors are now getting an approximate 5% yield by purchasing certain new bonds, they may rebalance their overall portfolio weighing it more towards bonds than stocks. This means they may have to sell some of their stocks which can depress overall equity valuations.  

By Justin Zacks, VP of Strategy, Moomoo Technologies Inc.

This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors.  It is provided without respect to individual investors’ financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. Past investment performance does not indicate or guarantee future success. Returns will vary, and all investments carry risks, including loss of principal.