Advice matters
How does inflation affect the sharemarket?

2022 will be remembered as the year central banks escalated their monetary policies with bigger rate hikes than expected, to try and reign in inflation.

As New Zealand’s current level of inflation shows, that battle is far from over. So, what does rising inflation mean for the share market? Let’s start from the beginning.

Why central banks have inflation in their crosshairs

Inflation isn’t always bad news: in fact, a certain level of inflation is good for a healthy economy, as it sustains economic growth. For example, a 1-to-3% inflation rate is the target range that the Reserve Bank of New Zealand considers sound.

The issue at hand now is that – despite the aggressive upward interest rate push we’ve seen since early 2022 – the current inflation hovers at much higher levels, having fallen only marginally from 7.3% to 7.2% in the third quarter of the year.

Without delving too deep into the reasons for this inflationary environment, these are some key contributing factors:

  • Demand-pull inflation: Prices increase when supply can’t keep up with an increase in demand for goods and services.
  • Cost-push inflation: Prices increase when production costs increase.
  • Rising wages: These contribute to inflation in two ways. When workers earn more money, they have more to spend on goods and services, so demand increases. At the same time, rising salaries lead to higher business costs and, therefore, higher prices.

An overheating economy eventually pushes up prices to the point where spending falls, pulling the economy into a recession.

To avoid this, central banks aim to slow borrowing and spending by making it more expensive for consumers and businesses to borrow money – hence the rate hikes. However, a tight labour market pushing up wages is making New Zealand’s core inflation particularly ‘sticky’.

What does this mean for the sharemarket?

Inflation is not necessarily bad for the share market. If companies can increase prices and pass on higher costs to consumers, inflation actually helps boost corporate profits.

But problems arise when inflation gets out of control. As we’ve seen, the only tool that central banks have at their disposal is increasing interest rates – and unfortunately, monetary policy is a blunt instrument.

More than inflation itself, investment markets tend to worry about the remedy (interest rate hikes), as it prompts them to expect earnings to fall. As credit gets more expensive, the cost of capital (equity and debt) for companies increases. And as a result, projected cash flows are valued lower, which translates into lower equity valuations.

It’s interesting to note that, according to S&P 500 data, inflation in 2022 has hurt share prices more than it has affected the companies’ business performance. This is because investment markets are not a reflection of current economic conditions, but rather of investor sentiment and aggregate expectations for the future. In other words, part of the recent market volatility has been driven by concerns around the use of rate hikes to control inflation.

Are some shares more sensitive to inflation than others?

As an investor, you may be wondering if all shares respond to inflation the same way. While there are no inflation-proof shares, it’s true that certain sectors and certain types of share are more sensitive.

Growth shares are often impacted by inflation more than others. These are shares in companies that have the potential to achieve above-average growth in profits over time. Value shares, on the other hand, are shares in companies that are trading below what they are worth, based on fundamentals like dividends, sales, and earnings.

In terms of market sector, some have historically performed better in times of high inflation. While past performance is never a guarantee of future performance, energy shares have confirmed to be inflation-resistant in 2022. Additionally, consumer staples, financial and utility shares often perform well during inflationary periods.

Looking at protecting your finances from inflation?

As financial advisers, we can help you devise a plan to protect your finances from rising inflation. Depending on your circumstances, you may look at diversifying your investment portfolio to achieve long-term returns while managing risks.

If you have any questions, please don’t hesitate to contact us. We’re here to help.

Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the information provided in this article, please use your discretion and seek independent guidance.