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How does inflation and interest rates affect the stock market?

Trading Guides
20 Apr 2023
Rising inflation and interest rates are stressful for many consumers – but not necessarily for you as a trader or investor in the stock market. We analyse how inflation and interest rates affect share prices and look at the best sectors for both environments.

First things first: What is inflation?

Inflation is the term for money losing value over time. So, even though £100 is still £100, for example, inflation increasing will mean that you can buy less with that £100 than you used to be able to. If you’ve ever noticed things becoming steadily more expensive in shops and being able to afford less with the same amount of cash, that’s inflation.

There are two main types of inflation, defined by what causes them.

Cost-push inflation is when the things needed to run our economies - like commodities, building materials, labour and the like - suddenly become more expensive. This could be due to scarcity and supply chain issues, for example, as it was with grain from the Ukraine after Russia invaded in 2022.

The second type of inflation, demand-pull inflation, occurs because the desire for important goods and services has increased significantly. For example, during an economic boom, infrastructure spend may increase in a country, while consumers with more money in their pockets are also spending more. As a result, the prices of these items are increased by producers and suppliers in order to make more profit.

So, then what is ‘CPI’?

If you’ve heard of inflation before, you might have heard the term ‘CPI’ thrown about. This stands for ‘Consumer Price Index’, and it’s a practical way to measure and benchmark inflation.

CPI refers to the average amount that prices have increased for certain store-bought items, such as groceries. The Consumer Price Index is usually measured to calculate by how much, in percentage points, these store-bought goods have increased or decreased in price over the past year or previous month. For example, if the same items are costing 5% more than they did last year, we say that ‘CPI is at 5%’.

However, this method of measuring the inflation rate has its limitations, especially when we’re looking for a broader way to categorise things becoming more expensive that aren’t just consumable goods in a store. Another way to measure inflation is with PPI - the Producer Price Index, which looks at how much costs have risen for the suppliers and producers of those store-bought items. Any increase in PPI will have a trickle-down effect to CPI as well.

What are interest rates, then?

The interest rate is the cost of borrowing money - first for lending institution like banks borrowing from the central bank, then for businesses and consumers getting loans from lenders like the banks.

Interest rates are set by a country or region’s central bank, which gives lenders like banks an acceptable current amount of interest to charge borrowers, like individuals or businesses applying for a loan or mortgage.

What’s the relationship between inflation and interest rates?

When inflation rises, central banks will often step in to prevent it spiralling into runaway inflation, which can result in a country’s currency becoming worthless. The way that central banks do this is almost always by raising interest rates.

The reason interest rate hikes are used is to prevent too much credit creation by people and businesses feeling the squeeze of inflation. While a higher interest rate will discourage too much borrowing, it also means less spending - so the trade-off for hawkish hikes is generally slower economic growth.

Rising inflation is very often followed by a rise in the interest rate, which often compounds the reduction in economic growth, as it means cash’s monetary worth dropping is followed by the price of borrowing rising. As a consumer, both generally impact your cost of living, albeit in different ways. However, inflation and interest rates will affect different asset classes in different ways:

·While several things can raise inflation (including macroeconomic turbulence), changes to the benchmark interest rate are always determined by the central bank. This means that interest rate changes have a more immediate impact on markets like stocks, indices, forex and more

·While inflation alone means cash itself depreciates in value, higher interest rates mean that savings are worth more, as the interest they’re accumulating increases. This means that more people will turn to holding cash savings, rather than investing in the stock market, as the returns of savings are likely to be higher in such an environment.

How inflation affects the stock market

Inflation impacts companies – and their share prices – in numerous ways, depending on the company and the industry. But what about the stock market as a whole?  

Inflation is caused by macroeconomic factors decreasing how much cash and other assets are worth. Things like wars or severe shortages of vital commodities such as oil or grain are just some of the scenarios that have led to periods of high inflation in the past.

This has a negative impact on the stock market in both direct and indirect ways. Firstly, inflation is almost always followed by interest rate hikes – which changes not only how the public borrows, but also changes how investors and traders operate.

Secondly, an interest rate hike and inflation (and the macro occurrences that caused it in the first place) means uncertainty, and markets as a general rule do not like uncertainty. Traditionally, indices like the S&P 500 (often considered a benchmark and indicator of the stock market as a whole by economists) will likely experience ups and downs, plus less gains overall, when these kinds of scenarios hit - especially if they’re sudden and unanticipated.

On a consumer level, they also change how consumers and businesses spend, reducing luxury purchases and the buying of bigger items – which will affect the share price of the industries selling those things, as well as stocks on a wider level, because less money is being pumped into the economy.

How interest rate hikes affect the stock market

When interest rates rise, the fact that it’s now more expensive to borrow has very real impacts on many asset classes – including the stock market.

Higher interest rates make consumers’ savings worth more, as we’ve said. This means that, in hawkish environments, investors and traders will see more reward in merely holding onto cash in the bank, rather than risking it on shares, whether buying them outright or speculating on the stock market. This too will affect equities’ popularity.

Adding to this, borrowing becomes more expensive when the interest rate rises, and so hawkish policies usually mean that companies will dial down any big investments or projects that would require a loan. This almost always affects a company’s stock price.

Recent history of inflation and interests affecting the stock market: an example

Let’s look at how interest hikes and inflation affected us in the real world, to understand some of these concepts better. When the Covid-19 pandemic swept the globe in 2020, central banks simultaneously lowered interest rates and delayed their rising afterward, in the hope of boosting a thoroughly shocked economy into spending again.

This worked - although inflation rose significantly during 2021 as a result. Then, in February 2022, Russia invaded Ukraine, setting off a chain reaction of spiralling commodities prices, uncertainty and, ultimately, another bout of inflation.

Central banks reacted by raising interest rates. The United States’ Federal Open Market Committee, for example, introduced a grand total of seven interest rate hikes in 2022 - the biggest cumulative tightening, in terms of basis points, in over forty years.

The results for indices were telling. Many of the world’s most prominent indices, representative by and large of the stock market, had their worst year since the 2008 global financial crisis. The United States’ Nasdaq index fell by more than 30% through the course of the year, while the S&P 500 was down more than 19% during 2022. At the same time, the Nikkei 225 index closed out 2022 with a fall of nearly 10% - its first in over four years. The United Kingdom’s FTSE 100 fared slightly better, yet managed to gain just 0.9% for the entire year.

Best inflation beaters: stocks that perform well in times of high inflation

Shares are generally put into two categories by investors: growth stocks and value stocks. One of these will do significantly better than the other when inflation rises.

Growth stocks are companies believed to grow in profitability and give returns at a faster rate than the average stock in their industry or index. While this is unsurprisingly attractive for investors, it’s directly impacted by how fast the economy as a whole is growing. In times of bullishness and economic booms, growth stocks do well. But, as we’ve mentioned earlier, high inflation and interest rates mean slow or even no growth for industries – and often growth stocks’ real returns suffer similarly as a result.

Value stocks, on the other hand, are more in the second ‘slow and steady’ category – and, in times of high inflation, it’s slow and steady that often wins the race. Value stocks are those that have been proven to give consistent returns over longer periods of time, even if they are often less spectacular returns than growth stocks. And while growth stocks see less interest when inflation and/or interest rates are high, value stocks often see renewed interest, due to their reliability.

The ‘lipstick effect’

There is a third type of stock that bears talking about when inflation is rising – those connected to the famous ‘lipstick effect’ theory.

Economists have noted that, when consumers are under the financial pressure of high inflation (and often rising interest rates too), there’s a predictable decrease in consumer spending, especially bigger luxury splurges like leisure travel. However, there’s also a discernible increase in the purchasing of smaller ‘feel good’ items as consumers reach for comfort in the short term, even as they try and tighten their belts longer term. This is called the lipstick effect, so named because economists noticed that sales of red lipstick went up in times of hardship, even as sales of more expensive frivolities like perfume went down.

According to the lipstick effect, more well-known brands which deal in smaller luxuries can do well when inflation rises. Things like cosmetics, junk food, alcohol and smaller fashion items can all benefit from the lipstick effect.

Examples of stocks that did well during inflationary periods

Note to readers: the following should not be taken as financial advice, merely a general guide as to stocks to potentially research in your own capacity. Also remember that past results are not an indication of future returns with any company and that markets are unpredictable, with no guarantees, only guidelines based on what’s happened historically.

  • Value stocks have traditionally done well, like some insurers
  • Sellers and distributors of consumer staples like toiletries and discount chain stores may also be value stocks
  • ‘Feel-good’ food item makers like chocolate or coffee companies
  • Cosmetics companies selling widely used makeup items

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Stocks that perform well when interest rates rise

What is true of stocks during times of high inflation is generally true during rising interest rates too. Higher interest rates generally mean companies will focus less on any business investment that requires significant borrowing.

But there is another type of shares that have historically done well in some hawkish times – bank stocks and other lenders.

Because lenders like banks charge interest, they may see an increase in profitability when interest rates are hiked by the Fed or other central banks, because they are now receiving more in the way of interest from their customers.

However, this has been known to backfire if interest rate hikes are so crippling that lenders default on their loans – proving the adage that past cases are no guarantee of getting the same results, even in a similar environment, in the future. There is still the risk of loss with any trading or investing, even when picking stocks that have done well in hawkish climates previously.

Examples of stocks that can do well when interest rates rise

Note to readers: the following should not be taken as financial advice. It’s merely a general guide on stock. Traders and investors should do their own research or seek the professional advice of a financial advisor. Also remember that past results are not an indication of future returns with any company.

  • Banking stocks traditionally perform well
  • Insurance stocks, particularly bigger, international insurers
  • Other big companies with financial services arms as a value-added service, like popular chain stores or bancassurers  

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