What is Inflation, and Why does it Affect the Stock Market?

Defining Inflation

When prices rise across the board in the economy, this is referred to as inflation. When you start to see costs go up all around you, from the gas station or grocery store to the car dealership or real estate market, and your income feels like it doesn't cover as much as it did just a few months ago, this is likely a sign that the inflation rate is on the upswing. As of June 2022, the inflation rate is at 9.06%. Over the course of the year, it has increased steadily, causing concern amongst civilians and policymakers alike. The current inflation rate is nearly 4% higher than it was at the same time last year.

Inflation is calculated by the Bureau of Labor Statistics using the Consumer Price Index (CPI). This method divides the cost of goods during a particular month by that of the cost of goods from the previous month. The prices of goods and services considered when determining the rate of inflation is decided by surveys from the Bureau that establish what people are buying.

The cause of inflation, especially at the rate we are seeing it today, is represented by a variety of factors. This can include but is not limited to supply and demand, production costs, and fiscal policies. Things like natural disasters and current events play a huge role in these factors as well.

For example, the war in Ukraine has severely impacted oil supply, as Russia supplies many countries, including the United States, with oil. By limiting the amount of imported oil from the country, gas prices have gone up exponentially. Russia previously provided the States with 20% of the oil used for the gas everyday people put into their cars. With less oil at our disposal and no difference in demand for the resource, the price is driven up. Some states have seen gas prices rise above seven dollars a gallon, with the average price sitting around five dollars a gallon. Comparatively, the average price of a gallon of gas in April 2021 was under three dollars. Gas is only one of many economic components affected by oil, accompanied by other things like heating and the transportation of goods and services. When prices rise like this, banks may choose to raise interest rates to combat the inflation, though this is not always the route taken.

How it Impacts the Market

Every stock is unique, and therefore is affected by inflation in different ways. While some sectors tend to struggle during a period of high inflation, others actually perform better. This makes it difficult, if not impossible, to predict how inflation will cause some stocks to do well and others to do poorly, so it's crucial as an investor to pay close attention to the companies in which you hold stock to determine a strategy that works for you when inflation is high.

When inflation rises to rates as we are seeing them today, the market can become bearish*. A bear market happens when a stock index has fallen 20% from a recent high. Since February of this year, we have been in a bearish market. Inflation has played a hand in this, as the markets react accordingly in such situations. Since stock prices tend to fluctuate, it's unclear how long we will see these high rates or when the market will climb back into bullish territory.

In contrast, a bullish** market takes place when both the highs and lows of the market are consistently higher than the previous highs and lows. This is typically an indicator that the economy is doing well, whereas a bear market shows the economy is performing poorly. The longest bull market in history lasted almost eleven years, ending at the start of the pandemic in March 2020. Since then, the global financial landscape has experienced many complications leading us to where we are today.

Protecting Your Investments

As the saying goes, don't put all your eggs into one basket. By diversifying your portfolio***, you set yourself up for success with a potential hedge against inflation. There's no way to know exactly how the markets are going to perform, so there is not a "best way” to invest or prepare for things like a bear market or high inflation.

For many, inflation can be a motivating factor to start investing. Historically, placing portions of your earnings in stocks has allowed people to acquire a passive income that can combat rising inflation in a way that cash cannot. However, this does not guarantee that you will see high returns if you choose to invest while the inflation rate is up. It's important to weigh the risks and benefits of investing before you take the plunge, though this is especially true when high inflation rates are impacting the costs of necessary goods and services.

While you can't predict the markets, you can remain alert and pay close attention to how they are operating in order to adjust your investment strategies. It's never in your best interest to attempt to time the market, as there's no way to know when it will peak. But, by sticking to a good strategy that fits your needs, you can protect your assets against potential loss when the markets aren't at their best.

*A bear market gets its name from the way a bear attacks: swinging its paw downward. It occurs when a stock index falls 20% or more from a recent high. This type of market shows lower lows and lower highs than a bull market.

**A bull market is the opposite of a bear market. It gets its name from the way it drives its horns in the air upon attack, plowing forward with speed. As you may assume, it occurs when a stock index rises 20% from a recent low.

***An investment portfolio is a collection of assets that contains any investments you hold. This can include stocks, ETFs, bonds, or any other investment you may have. The phrase "don't put all your eggs in one basket” emphasizes the importance of having your funds distributed throughout a variety of products, so instead of putting everything into one stock, you use the same money to buy a few different stocks and ETFs, or whatever you may choose. This can prevent significant loss and gives you more opportunities to profit from your investments.

Disclosure: All investments involve risk, and not all risks are suitable for every investor. The value of securities may fluctuate and as a result, clients may lose more than their original investment. The past performance of a security, or financial product does not guarantee future results or returns. Keep in mind that while diversification may help spread risk, it does not assure a profit or protect against loss in a down market. There is always the potential of losing money when you invest in securities or other financial products. Investors should consider their investment objectives and risks carefully before investing.