Will spiraling inflation blow up the stock market?

More inflation is coming, and it could hurt your portfolio, at least in the short term.

Inflation has been a buzzword throughout the year, as supply chain issues and additional savings for U.S. consumers have driven up prices for goods ranging from real estate and cars to bacon. Consumer prices jumped 6.8% in November from a year ago, the biggest price increase since 1982.

So far, the rise in prices has done little to stifle a strong stock market rally, with the S&P 500 on track for gains of nearly 24%. But that doesn’t mean market participants aren’t worried, especially since the Federal Reserve has announced plans to hike interest rates three times in 2022 to help curb price increases.

The biggest risk to the market is an overly aggressive rate hike strategy by central banks followed by inflation, according to a monthly Bank of America survey of fund managers. Meanwhile, 25% of Americans say rising inflation is the biggest risk to their retirement plans, a share that has more than doubled since 2020, according to an annual study by the Allianz Life Insurance Company of North America. .

How much do you need to worry about inflation and the Fed’s response to it? Not a lot. In the short term, there will likely be more volatility in the market and stock prices could suffer as borrowing costs have increased and companies may have to absorb higher raw material or labor costs. work before passing price increases on to their customers.

Over time, however, the impact is less obvious because stocks offer a “pretty good hedge” against higher inflation, notes Ross Mayfield, investment strategy analyst at Baird. “Generally, the stock market has performed quite well over the past 40 to 50 years during times of higher inflation.”

A notable exception was the 1970s, when stocks fell into a bear market amidst a period of stagflation (persistent high inflation accompanied by high unemployment). And because inflation hasn’t been a concern for investors in recent years, some market watchers have called the 1970s a caveat – a comparison that Mayfield says is unwarranted.

“The economy today is really, really different,” Mayfield notes, adding that the job market is “as strong as we’ve seen it for decades.” As a result, when businesses raise their prices now, consumers can, on the whole, “absorb” those price increases in order to keep spending. “Inflation is not to be feared at all.”

How inflation affects businesses

The headline inflation rate masks some of the large variations in price increases (or even decreases) in various industries. Just as it is important for consumers to calculate a “personal” inflation rate, investors should consider the impact that higher inflation might have on the stocks in your portfolio.

Firms that purchase raw materials will immediately feel the effects of rising commodity prices, while firms that sell finished products or provide services may experience a delayed effect from rising costs of transporting items and paying workers. During times of high inflation and high interest rates, investors tend to favor value stocks, especially those in the materials, industrials, finance, energy and consumer staples sectors. Mayfield notes. Some growth stocks, including tech companies, have also performed well over similar time periods, as they have the ability to pass price increases on to established customer base, he adds.

While some investors may try to make changes to their portfolios to capture the different effects of higher inflation, an argument can also be made to focus on diversifying your portfolio. “It’s important to really spread your exposure between stocks, bonds and real assets,” advises Eric Freedman, chief investment officer at US Bank.

It is also very important to stay invested in the market, even if stock prices become more volatile as market participants try to understand higher inflation and the Fed price to raise interest rates. Freedman and colleagues predict that the S&P 500 will end the year at 5,060, up almost 9% from its current level.

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The arguments in favor of total ignorance of inflation

Just as the market has apparently brushed aside concerns about inflation this year, so do investors. Indeed, higher inflation is both a factor in supply and demand problems which are inextricably linked to the pandemic; Supply chain problems are partly to blame, while demand has increased partly because of stimulus checks given to Americans.

“It is difficult to separate traditional inflationary pressures from the cause and effect of pandemic problems,” Mayfield said. This momentum has also been difficult for central bankers, who initially called inflation “transient” and pivoted their strategy more recently.

With so many uncertainties still surrounding the pandemic, greater volatility is expected to continue as investors make sense of higher inflation and looming interest rate hikes. Even so, stocks continue to offer the best return for investors – and Mayfield says large-scale portfolio changes are not justified for long-term investors.

“Take a long-term perspective,” adds Freedman. “Have a plan and have the opportunity to revisit that plan as the facts change.”

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