Inflation Gets a Lot of Airtime in Economic News Stories, but What Does it Actually Mean in the Real World?
If you follow news about the economy, there seems to be a lot of concern around inflation. Inflation is rising. Inflation is falling. The Fed is meeting to discuss interest rates and inflation. What does that actually mean, though, as we live our lives? More specifically for our purposes, how does inflation impact our investments?
If you ask the Cambridge Dictionary, inflation is “an increase in prices over time, causing a reduction in the value of money.” That sounds a little scary. And, in fact, inflation is widely believed to be detrimental to bonds, but there are conflicting opinions on how it influences stocks.
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Inflation and the value of your stocks
On one side, stocks are considered to be a hedge against inflation because their underlying productive facilities generate revenue that increases in proportion to inflation (while bonds are mere claims against dollars).
But historically, stocks have delivered above-average returns at times of low inflation and below-average returns at times of high inflation. Why is that?
While it’s true that stocks are backed by productive facilities that generate revenues that are hedged to inflation, the income-generating facilities are susceptible to inflationary pressures. So to understand the forces that nullify the inflationary advantages on revenue, we need to take a look at how inflation acts on the components of a business.
On the asset side of the balance sheet, inflation increases the replacement cost of both inventory and fixed assets, while receivables increase in proportion to the inflationary growth in revenue.
On the liability side of the balance sheet, inflation results in an increase in leverage by less profitable companies to sponsor their capital requirements. Altogether, the assets and liability sides of a company’s balance sheet will bloat in proportion to inflation.
On the equity side of the balance sheet, we need to factor various costs that are directly associated with expanding assets and liabilities. Increasing replacement costs of inventory and fixed assets will increase the cost of goods sold and depreciation expenses. At the same time, growing liabilities in the less profitable companies, along with rising interest rates, will result in higher overall interest expenses.
So, getting back the original question: just how does inflation affect stocks? In a nutshell, the positive impact of inflation on the top line will be nullified by various associated costs, resulting in a neutral bottom line.
So the equity side of the balance sheet faces almost no impact from inflation, resulting in a neutral return on equity but a higher debt-to-equity ratio.
A real-world example of inflation
To understand how inflation works in practice, consider the outbreak of African Swine Fever that decimated China’s hog population in 2018. Now compound that problem with historic flooding in the U.S. Midwest that destroyed cattle, pigs, grains and planting fields, and you’ve got a probable food price inflation situation. In addition, rising labor costs get passed on to consumers and therefore contribute to food price inflation. Rising inflation naturally leads to rising interest rates, which then puts pressure on stock and bond prices. Thus, the inflation of food prices could put a damper on your portfolio down the road.
With so many variables, what can you do to protect your portfolio? Companies that have grown their dividend consistently reflects not only consistent earnings growth but management’s commitment to the dividend. Growing dividends is a great defense against inflation. Unlike bonds, dividend stocks can increase payments during times of rising prices.
Additionally, dividends are fantastic wealth builders. Reinvesting dividends has a compounding effect on an investment, delivering jaw-dropping returns over time. Reinvested dividends buy more shares of stock. More shares of stock pay still more dividends. And if the dividends grow and the stock price appreciates, the returns can be astounding.
To find out more about dividend stocks and how you can avoid the worries of inflation, download our free report, The Five Best Dividend Stocks to Buy Today.
What worries you most about the effect inflation has on your investments? Let us know in the comments.
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