How does inflation affect stocks?

Investing long-term in the stock market could be a solid stepping stone to growing your family's wealth. But with higher prices looming large, you may wonder how inflation might affect your stock investments, and if you should even be investing during inflation. That's a natural worry. According to Thrivent's 2022 Consumer Financial Outlook Survey*, 63% of people said inflation is pushing them off track financially.

But while it takes a certain approach, investing in stocks during inflationary periods is possible and potentially even profitable with the right variables at play. Let's dig deeper into the relationship between inflation and stocks so you can make sound investment decisions for your family's financial health.

Inflation occurs when there's an imbalance of supply and demand for goods and services. When the total demand for goods and services exceeds the total supply, prices tend to rise. They tend to drop when the opposite happens.

Inflation was relatively low in the U.S. economy for three decades. But 2022 experienced the highest inflation increases in 40 years. While it has begun to cool, inflation has remained above historical averages in 2023.

Rising costs and uncertain revenue growth can take a toll on corporate profit margins, and stock prices can fall in response. On a broader scale, high inflation creates unknowns about future interest rates. That uncertainty often contributes to market volatility.

Ultimately, it's tough to definitively say how inflation impacts stock market returns, when inflation is just one of many variables at play. One way inflation comes into consideration is its correlation with the Fed's interest rate hikes—and expectations about the timing and size of future hikes. Higher interest rates can discourage businesses from borrowing money to expand operations, for instance. Fears about the economy dipping into a recession also can play a role.

The stock market's ups and downs can be difficult to stomach. But holding equities during periods of high inflation could be beneficial for a couple of reasons.

For one, stocks are considered an inflation hedge against soaring prices. They could help you equal or outpace the average rate of inflation over the long term. In fact, stocks have been doing this for investors for quite some time.

The S&P 500, an index that represents the average performance of a group of 500 large capitalization stocks, has gained about 10.7% on average annually since 1957. Yet, the inflation rate in the U.S. averaged 3.28% from 1914 to 2023.

Also, since sharp rebounds often follow periods of decline, you could be rewarded for staying invested with stocks. Following the 10 bear markets (declines of 20% or more) since 1950, the first three months after the bottom saw returns bounce back 20.9% on average, while the first full year climbed 43.4% on average. Those bounces can be worth waiting for.

Notably, some stocks perform better in an inflationary environment than others. One reason has to do with that connection between inflation and rising interest rates. When interest rates are high, value stocks tend to perform better than growth stocks.

Growth stocks are typically companies whose shares are expected to grow at a faster rate than the market average.

• Growth stocks attract investors willing to pay a higher price now because they have high hopes for the company's future growth. They're expecting a nice payoff when they sell their shares.

• These stocks typically don't pay dividends, so being a shareholder doesn't offer you regular income from your investment.

• Growth stocks generally have a large presence in their industry. Tesla is one example—it dominates the electric car industry and is expected to continue to outperform the market average.

Value stocks, on the other hand, tend to be cheaper. They're companies that have a low price-to-earnings (P/E) ratio, which compares a company's current share price to its earnings per share. A low P/E ratio might seem like a bad sign, but it could mean a company's stock is undervalued. A low P/E doesn't always indicate poor company performance.

Many value stocks belong to mature but steadily growing companies with stable revenues and earnings, with Berkshire Hathaway being one example.

• Value stocks often pay dividends and generally lead to higher returns over the long term.

• When considering value stocks, look at the company's fundamentals—earnings, sales, dividends, etc.—to compare the lower-priced shares against actual performance. This can give you an idea of whether the share price is currently undervalued or has been caused by negative business metrics.

With all that said, it's not always clear which stocks belong in which category. The internet is full of opinions about where Apple falls, for instance.

Likewise, it's become hard to assign sectors to one style or the other. Consider the S&P 500 Pure Growth index and the S&P 500 Pure Value index. Each contains S&P 500 equities that the index creators deem to exhibit the strongest growth or value characteristics. In August 2023, you could find financial, health care and energy companies in both indices.

The growth style has generally outperformed value over the past decade. While the Pure Growth index earned a 13.13% 10-year annualized return through late August 2023, the Pure Value index returned 10.74%.

Inflation and interest rates have introduced a slight twist. As of late August 2023, the value index has a one-year return of 1.43%, while its growth counterpart has a dismal -1.06% return.

Value investing can be a smart strategy in a high-inflation, high-interest-rate environment. Though all investments have risk, buying undervalued stocks of companies with strong business fundamentals can be less risky and costly than buying growth stocks. High interest rates can harm the above-average growth of those companies investors are banking on.

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High interest rates & inflation: What that means for you

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With inflation prominently in the picture, it's important to understand the difference between a nominal rate of return and a real rate of return.

The net gain or loss over a time period before adjusting for factors like inflation and taxes. While it can help you compare the various stocks' performance, it doesn't provide the whole picture you need to evaluate an investment.

Accounts for factors like inflation and taxes. The real rate of return is lower than the nominal rate of return when inflation is present.

Here's an example that uses simple calculations and ignores taxes and other factors: A stock that generates a 9% return over one year has a 9% nominal rate of return. However, when the inflation rate is 5%, the real return rate is only 4% (9% minus 5%).

High inflation doesn't need to throw your financial goals off course. Consider how you might invest during inflation with these tips.

Watching your account values fluctuate can cause some understandable financial anxiety, but avoid exiting the stock market out of panic. You could end up missing out on gains when markets rebound. A buy-and-hold strategy can pay off for you over the long term.

Consider a dollar-cost averaging strategy to take some of the emotion out of investing. This is where you invest a set amount at fixed intervals. You can avoid second-guessing yourself if you automatically deposit a fixed amount of money into a stock every week or every month. Plus, the strategy can help reduce the effects of volatility because you can purchase more shares when prices are low and fewer shares when prices are high.

On that note, remember that a slumping stock market can provide an opportunity to find good stocks that are essentially on sale.

As in times of low inflation, it's wise to build and maintain a well-diversified portfolio. While value stocks typically show strength during periods of inflation, it could be risky to limit all your holdings to those equities. Growth stocks may rebound one day. Aim for a mix of assets that fit your risk tolerance and account for the amount of time you plan to stay invested.

Your investment portfolio isn't set and forget. Review how your investments are working for you with a financial advisor. If your original target allocations of stocks, bonds and cash have shifted in a way that no longer matches your risk tolerance and investment objectives, it may be time to rebalance.

Inflation can add complexity to investment decisions that can be hard to navigate in the best of times. Consider connecting with a Thrivent financial advisor to gain personalized insights and guidance. They can help you identify ways to help protect your stock investments from inflation during volatile times and keep your financial vision on track.