What role does inflation play in the bond and stock markets?
Inflation must be carefully balanced in order for bonds and stocks to perform well. If inflation is too high, it erodes purchasing power. If it’s too low, there’s a risk of falling behind foreign rivals.
The effects of inflation on the stock market are complex and there isn’t a catch-all rule to be applied to all shares. However, we can say to a certain degree the probability of how inflation rates might affect a company’s share price.
Typically, growth stocks, those aimed at growing over the longer term with less value in the current, benefit from lower inflation levels because their value is determined on what their future earnings are going to be. When inflation rises, interest rates rise with it, which erodes the value of future company earnings.
On the other hand, value stocks, which are priced lower than their intrinsic value, tend to fair better during high-inflation periods. This is because their larger current cash flows are more valuable than those of growth stock’s distant potential returns. Investors need to see higher returns when inflation rises to make ‘real’ returns, so they tend to stick to stocks that can withstand increased inflation in the present.
For fixed-return bonds, inflation will always have a negative impact, because if the rate of return on the bond is lower than that of inflation, real returns are negative. However, inflation-linked bonds aren’t negatively affected by rising inflation, as they’re linked to price indexes. So, investments in inflation-linked bonds won’t be impacted by rising or falling inflation rates.