Why do stock prices go down when inflation is high?

As anyone who monitors the value of their pension or investment account will have felt this year, stock prices have experienced some sharp declines. The main reason: Global inflation has been hitting record levels – the highest in the US since the early 1980s and the highest in the UK in three decades.

Inflation is defined as ‘a general increase in prices and fall in the purchasing value of money’. The latter part of the definition ought to make one wonder: If the value of money is falling why are stock prices falling even faster? Surely they should be rising relative to money – not the other way around?

Here are two key reasons for this phenomenon:

1. Theoretically a stock’s price takes into account the expected future profits of a business. Since inflation involves money declining in value, the company’s future money profits also have less purchasing power than previously expected. The stock price, therefore, declines accordingly to take this into account, which compensates those who are on the sidelines looking to invest.
2. To tame inflation and bring it back down, central banks are slowly raising interest rates and are expected to continue to do so until they achieve this objective. The rate of interest is essentially the price of money and so influencing a higher interest rate ought to make money more valuable or at least reduce the rate at which it loses value. How does this impact share prices? Opportunity cost is an important concept in investing: A higher interest rate environment provides investors with safer, more predictable alternatives to the risk of investing in company shares. Stock prices, therefore, need to come down to stay competitive in this new investment landscape.

Note that both causes I have outlined are mostly based on predictions rather than concrete facts. Here is why such predictions may prove to be wrong:

1. If businesses can successfully raise prices to keep up with inflation, the impact of inflation on future profits will not be negative. Therefore investing in high quality businesses in the right industries with leading brands, strong growth prospects and extremely talented management ought to provide some safety in tough economic conditions.
2. Can central banks really raise interest rates enough to tame inflation without causing massive economic damage? Consider the following point: Government, corporate and consumer debt levels were at record levels before the pandemic.

Multiplying interest costs in a global economy that is more or less addicted to debt can lead to a disastrous ‘domino effect’ of loans not being repaid. Even if such tough-tasting medicine eventually works as a cure, is there really the political will to inflict such pain?

Although economics is hard to predict and I could easily be wrong, it makes more sense that interest rate rises will not be able to go much higher and inflation will be allowed to erode the value of debt. It is politically much safer to allow government debt to be paid indirectly through higher consumer prices than directly through spending cuts and tax increases.

To conclude, my guess is that the market is reacting in the wrong way. However even if it is reacting in the right way, having a long investment time horizon and not panic selling is still likely to be the best approach, depending on what's in your portfolio.

Disclaimer: This article does not constitute financial advice.