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How inflation affects the stock market

(MoneyWatch) With many investors worried that inflation could surge, it's important to consider how the markets have reacted when such inflation actually occurs. Fortunately, there's a study that can shed some light on this issue.

Since World War II, stock returns have done relatively poor when unexpected inflation occurs. This is because unexpected inflation causes investors to demand a higher risk premium for stocks. Chao Wei, economics professor at George Washington University, attempted to answer the following questions:

  • Does the stock market react to unexpected inflation differently across the business cycle?
  • Are certain stocks affected more by unexpected inflation?
  • Are the responses asymmetric across the business cycle?

First, the study found that there's strong evidence that the returns of growth stocks have been more negatively correlated with unexpected inflation. Growth stocks are longer duration, and thus an increase in the risk premium impacts them more than it does value stocks. In addition, value companies typically are characterized by having more leverage, and inflation reduces the real cost of fixed-rate debt.

The study also found that the more "growthy" the stock (as measured by book-to-market ratio), the stronger the negative correlation between its returns and unexpected inflation at the time of recession.

The link between unexpected inflation and stock returns changes depending on whether the economy is contracting or expanding. The risk premium for investing in stocks responds much more negatively to unexpected inflation during contractions than expansions.

The 1970s provide a good example of the relationship between unexpected inflation and the value premium. During this period, the inflation rate averaged 7.4 percent, even though its historical rate had been 3.1 percent. The value premium (the annual average return of value stocks minus the annual average return of growth stocks) jumped to 8.4 percent, well above its historical average of 4.7 percent.

Investors can use this knowledge when making asset allocation decisions. Investors who are more prone to the risks of unexpected inflation may wish to have lower exposure to more growth-oriented stocks. Similarly, investors who hold portfolios that are more growth-oriented may wish to reduce their exposure to inflation risk either by reducing the maturity of their nominal bond holdings and/or increasing their allocation to TIPS.

For those interested in learning more about the correlations of inflation and growth and value stocks, I suggest you read Bill Bernstein's excellent piece on the subject.

Money stairs image courtesy of Flickr user 401(K) 2012

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