How Inflation Can Threaten Stock Gains in 2018

NYSE

In times of financial prosperity it is easy for people to panic at any event which threatens to erode their profits made in the stock market. Technically this is called the psychology of the market, but people with common sense are more likely to see it as a knee jerk response to nervous investors. The basic idea of selling high after buying low will always apply, but trying to hit exact highs and lows is futile. Cashing out just below the top is no crime, and as for buying low there always seems there is a time for doing that.

There is more than one type of inflation rate. First, the rate most people are used to seeing reported is the rate calculated using the Consumer Price Index (CPI). But there is a more stable measure of inflation called core inflation. This is the inflation rate minus the price of food and gasoline. It seems strange to exclude two of the most basic expenses of the American household from calculation, but they are the two most volatile groups. The core inflation rate was 1.78% while the CPI inflation rate was 2.1% for 2017. The wider the gap between the two numbers, the smaller the chance there is that investors will have to worry about a rate increase by the Federal Reserve Bank.

The first threat to your stock portfolio will depend on the industry sectors you are currently investing in. Rising inflation rates will affect utility and telecommunication companies almost immediately, bringing down the price of their stock. But there are sectors that would definitely benefit from increased inflation. These include financial stocks (think credit card APR increases) and energy stocks (which basically pass along the cost to the consumer). Bank stocks can be added to this group (higher interest rates on loans and mortgages).

On the negative side of the ledger will be the costs to consumers. First, employees would be expecting cost of living increases every year from their employers, increasing company overhead expenses. That would force companies to decide whether that increase, which usually accounts for more than 45 % of a company’s bottom line expenses, is manageable or whether they would have to increase the price of their products and services. Those would be passed on to consumers, the same ones who are employed by the companies who are giving the cost of living increases. The effect on a specific stock would depend on the company’s profit margin affected by the increasing inflation rate.

Inflation causes commodity prices to rise, and depending on the product a company is selling the increased prices of commodities can drastically affect the cost of manufacturing. Certainly stocks that are invested in commodities such as gold would rise, as well as the price of the commodity itself. A growing economy means that more people are buying products, which increases the demand for the commodities. The basic law of supply and demand will mean that if the supply cannot keep up with the increased demands of a growing economy, the price of commodities will increase. That also will trigger inflation and affect the price of stocks…

The question is whether inflation is always bad for the stock market. As a matter of history, low inflation rates are good for stock prices, as long as the inflation rate does not remain low for an extended period of time (years, not months). When inflation rises to a moderate level stock prices will bump up, then plateau. Stock market prices declined sharply in 1929 (The Great Depression), 1975 (The Oil Embargo), and 2007 (The Great Recession). Apart from those three events, stocks generally trend upward over the long term, which is why professional investors and economists recommend holding stocks for the long term.

As for 2018, the question is whether inflation can stall the current bull market. Inflation has been low, 2.5% or less, since 2007 so you will need to keep an eye on the return your stocks are giving compared to projected increases by the Fed. The new tax changes tax qualified dividends and long term investments at 15% for investors making less than $418,400 (filing single) and $470,700 (married, filing jointly). The qualifying period is 12 months, so if you bought your stocks in January of 2017 you can cash out at any time and get the 15% tax rate on your profit.

Given the historical trends, you can expect inflation to go up this year, so you need to evaluate your portfolio every time the Fed announces a hike in the Fed rate. One financial publication reported that commodity prices increased by 15% since the end of August, a number that cannot be ignored if you have stocks in companies that manufacture products. This increase is likely to impact consumer prices sooner or later, which will then increase the core inflation rate.

You might also keep an eye on the price of gas because remember that the gap between the more inflation rate and CPI inflation rate is likely to cause the Fed to act. If the price of gas remains stable but the core inflation rate grows, that gap can narrow quickly and cause further concerns over the future of stock market prices. If you own stock, the early months of 2018 are likely to tell you a lot about the potential impact inflation will have on your portfolio.

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