What is Inflation and How Does it Affect the Financial Markets?

What is Inflation?

To put it simply, inflation is defined as the rate of increase in the general price levels of goods and services in a particular economy. The two main types of inflation are:

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How Does Inflation Affect Stock Market Returns?

Since the stock market is one of the largest financial markets, this article will be covering how it is affected by inflation. We can examine historical returns during low and high inflation periods in the hopes of offering a clearer picture to investors. Unfortunately, these analyses show conflicting results once factors such as time and geographical locations are considered. Many of such studies show that expected inflation can have a negative or a positive impact on stocks, based on the monetary policy and an individual investor’s hedging ability.

However, assessments of unexpected inflation result in more definitive findings, the most notable of which is a strong direct relationship between economic contractions and stock returns, portraying that the economic cycle is a crucial factor in gauging stock return impact. This positive relationship can also be due to the fact that unexpected inflation often reveals novel information regarding future prices. Likewise, higher stock movement volatility was related to higher rates of inflation.

Since the 1930s, almost all countries endured their worst real returns during periods where inflation was high (you obtain real returns when you deduct inflation from nominal returns). An examination of S&P 500 inflation-adjusted returns during every decade showed that the peak real returns occurred when inflation was between 2 and 3 percent. An inflation rate higher or lower than this suggested a macroeconomic environment containing larger issues that might have a varied impact on stocks. Perhaps, elements such as return volatility, inflation causes, and understanding how to invest in such an environment are more important than the actual returns.