Investing in an Inflated Economy

Inflation: Why is it Happening?

Data shows that, in addition to the highest annual inflation rate in 13 years, there has been an 8.6% annual increase in producer prices, a metric measured by the producer price index (PPI). Producer prices commonly increase in response to inflation, as a means by which businesses attempt to recoup losses. Both CPI and PPI data are published by the Bureau of Labor Statistics.

These increases are reasonable and expected in the wake of the COVID-19 pandemic, which effectively halted the global economy for months. Although many factors contribute to the current rise in inflation, including efforts to improve pandemic conditions, evidence suggests that current market inflation is primarily driven by the following factors:

• Labor shortages. A shortage of workers can put pressure on businesses to raise wages in an effort to attract new staff. Some businesses recoup labor costs by raising their prices, which subsequently raises PPI.
• Disrupted supply chain. Supply chain issues, such as product shortages and halted production or transit lines, contribute to a limited supply, which drives up demand. Increased demand drives up a product’s price, further fueling inflation.
• Pent-up demand. As more people receive COVID-19 vaccinations, businesses reopen, and federal aid supplements the economy, consumer spending continues to surge. Consumers are expressing sudden, high demand for services they forwent during the height of the pandemic, such as flying and staying in hotels.
• Rising energy prices. Surging energy prices driven by geopolitical forces, disrupted supply, and a reopening global economy may force business owners to raise prices to make up for money spent on energy-related costs. The market experienced rising commodity prices and raw materials prices overall, as a result of production cuts and unexpectedly high demand that increased the price of materials like lumber, steel, and copper.

Inflation affects industries across all sectors, but it has a pronounced, direct effect on the financial services industries. When it comes to investments, the effect depends on the type of investment in question.

How does inflation affect stocks and similar holdings?

Consider how the following types of investments fare during times of high inflation:

• Savings. Even if funds are secured in a savings account with an average interest rate, inflation can shrink the value of savings dramatically. When an individual is working, earnings should theoretically keep up with inflation; when individuals are forced to live off of savings, inflation diminishes purchasing power.
• Fixed income investments. When inflation rises, the purchasing power of interest payments declines. This is because the rate of interest stays the same on most fixed-income securities until maturity. As a result, bond prices tend to fall as inflation increases.
• Stock investments. Although some stocks hold up well against inflation, stock investments are negatively impacted in an inflated economy. According to long-term economic research, “Most of the empirical literature reports a negative relationship between inflation rates and stock returns in the post-1953 era.” Large U.S. stocks tend to decline in price alongside increased inflation.
• Alternative investments. Commodities and real estate investments have a positive relationship with inflation and tend to perform well in even highly inflated economies. Inflation is measured as the rising price of goods and services, which either directly contains commodities or are closely related to them.

Shareholders are not the only ones at risk for inflation-related investment losses; inflation can also indirectly affect people who do not actively invest. Retirees who depend on social security to supplement their income are vulnerable to rising inflation, as the trust funds for social security only invest in U.S. treasuries, which don’t keep up with inflation. In an effort to mitigate inflation’s impact on retirees, the federal government issued a 5.9% boost in benefits for 2022. While necessary, these boosts deplete an ever-dwindling reserve of funds.