What Inflation Does to Your Investments

Posted by Jacob Radke
September 19, 2023

Positive year-over-year growth in oil and gas is causing a rebound in inflation. With that, I thought it would be good to talk about how and why inflation is an important metric to watch for all investments and how it actually affects markets.

Last week, US inflation data was released, and it showed year-over-year overall inflation was 3.7%, which is 0.7% higher than it was a couple of months ago.

That was largely driven by higher energy prices.

But what that does is put pressure on the Fed, which controls short-term interest rates. Long-term interest rates are more market-driven.

The interest rate calculation equation is i-rate = base rate + inflation expectation + credit risk premium + maturity premium.

When investors expect inflation will rise, the yield on a bond must rise to win investors' favor for investing in that bond. That causes the price of existing bonds to fall, and it falls more for bonds with a further-out maturity date because you will get a lower yield for longer.

It can get slightly more complicated than that, but that is the nuts and bolts (when inflation expectations rise, bond yields rise, causing bond prices, especially those with longer maturities, to fall).

In the stock market, it's a bit more nuanced.

It comes down to several factors.

Inflation affects stock prices by:

  1. Deteriorating the underlying business's fundamentals, i.e., affecting profit margin.
  2. Changing the fundraising environment.
  3. Changing the risk appetite for investors.

All three of those factors, when placed in a vacuum of inflation, contribute to a stock's changing price.

Companies can stand to benefit and suffer depending on the business itself.

When inflation rises, some businesses cannot pass along their increased costs to their consumers. That leads to a deteriorating profit margin, which likely means less profit.

Some companies are very good at passing along their increased costs to their consumers, which makes that business more attractive in periods of higher inflation.

Fundraising is an interesting component. There are two main ways companies raise more money: they issue new stock, or they issue bonds.

Each has its benefits at different times. Right now, neither is great.

Issuing a bunch of new stock while the stock price is high is very attractive for the company. It allows them to get more money for less (lower cost of capital). When the company's stock price is low, issuing new shares is not attractive because it has to give up more for the same amount of money (higher cost of capital).

When bonds and debt have higher interest rates, they weigh on the company's income statement and balance sheet. It requires the company to become a better allocator of capital. If it issues $10 million in new debt at 6%, it has to be able to generate a positive return with that $10 million in excess of 6%, and more to actually make it attractive to other investors.

When rates were 0%, moonshot ideas were much more prevalent.

And lastly, risk appetites. In every instance when inflation grew higher than 5%, a recession followed. When a recession is on the horizon, it becomes much more of a concern to take undue risk. That causes the valuation metrics on stocks to fall, causing price declines.

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