Last Updated on 19 September, 2022 by Samuelsson
Annual Stock Returns and Inflation? How Does Inflation Affect Stock Returns Historically?
Inflation is one of the economic indicators investors keep an eye on. However, the relationship between inflation and annual stock returns is not straightforward. But you might want to know how inflation has affected stock returns historically.
The relationship between inflation and stock returns is complex. However, higher inflation is generally considered a negative factor for stocks because it reduces expectations of earnings growth, putting downward pressure on stock prices. Moreover, it increases borrowing costs, increases input costs (materials, labor), and reduces standards of living, all of which reduce companies’ earnings.
We’ll discuss this under the following subheadings:
- Annual stock returns: what does that mean?
- What is inflation?
- Understanding the relationship between stock returns and inflation
- How does inflation affect stock returns historically?
- Applying that in your trading method
Annual stock returns: what does that mean?
The annual stock return, also known as an annualized return, is the return a stock makes over a period of time, expressed as a time-weighted annual percentage. It does not only express the stock’s increase in value over a designated period, because the sources of returns can include dividends, returns of capital, and capital appreciation.
Typically, the rate of annual return is measured against the initial amount invested and often represents a geometric mean rather than a simple arithmetic mean. To calculate an annual return, you will need information about the current price of the stock and the price at which it was purchased. And if any splits have occurred, the purchase price has to be adjusted accordingly.
The simple return percentage is calculated as the current price minus the purchase price and the difference divided by the purchase price. The figure is then annualized by getting the geometric mean over the period of investment.
What is inflation?
Inflation can be defined as the decline of purchasing power of a given currency over time. That is, it is the rate at which the value of a currency is falling or the rate at which the general level of prices for goods and services is rising. Since the rate at which the decline in purchasing power occurs can be quantitatively estimated from the increase of an average price level of a basket of selected goods and services in an economy over a period of time, the rise in the general level of prices, often expressed as a percentage, is used to express inflation.
In essence, inflation means that a unit of currency effectively buys less than it did in prior periods. It measures the overall impact of price changes for a diversified set of products and services and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.
Inflation can be contrasted with deflation — a situation where the purchasing power of money increases and prices decline. Depending on how you view it and the rate of change, inflation can be seen in a positive or negative light.
Understanding the relationship between stock returns and inflation
Like most people out there, you understand the fact that inflation increases the price of groceries or decreases the value of what you can purchase with the dollar in your wallet. But inflation goes beyond that; it affects all areas of the economy, including the returns on your stock investment.
This is how it works: when a currency loses value or prices of goods and services rise, a unit of the currency buys fewer goods and services. Since this loss of purchasing power impacts the general cost of living for the common public, it ultimately leads to a deceleration in economic growth. Initially, companies may be able to pass on the extra cost of operations to consumers in the form of higher prices for their products and services, but as inflation rises, it becomes more difficult, leading to a reduction in their profit margins and earnings.
Economists believe that sustained inflation occurs when a nation’s money supply growth outpaces economic growth. So, to combat this, the central banks (for example, the FED in the US) take the necessary measures to manage the supply of money and credit to keep inflation within permissible limits and keep the economy running smoothly. They often rate interests when inflation is high. This increases the cost of borrowing and in effect, the cost of running a business. This further reduces profit margins for companies and reduced returns for investors.
How does inflation affect stock returns historically?
Now, let’s examine historical returns data during periods of high and low inflation. While there have been numerous studies that looked at the impact of inflation on stock returns, the results are conflicting when several factors, such as geography and time period, are taken into account. However, most studies conclude that inflation can either positively or negatively impact stocks, depending on the government’s monetary policy and the level of inflation.
Take a look at the bar chart below:
The chart shows that the worst real returns are earned during high inflation periods — inflation > 10%. The best returns are earned when inflation is greater than 0% but less than 5% followed by when inflation is less than 0% and when it is between 5% and 10%. When inflation is greater than 10%, the returns fall drastically. Note that real returns are actual returns minus inflation.
The reason may not be far-fetched. When inflation is extremely high, say more than 10%, the central bank is likely to aggressively increase interest rates, which would increase the cost of operation of many businesses and reduce their profit margins.
Businesses and individuals find it expensive to borrow funds. What usually follows is a decline in economic activities, and in many cases, a recession. That is, extremely high inflation heralds a recession in the economic cycle, especially if it is followed by aggressive monetary rate changes. This will also reflect in the equity market as a bear market.
Thus, as a stock investor, you should be mindful of periods of extreme inflation. It’s important to watch for changes in the monetary rates, and you may consider hedging your investments or moving to safe-haven and inflation-friendly assets, such as bonds and gold.