Inflation, Deflation, and Stagflation: How Do They Impact Investment

Inflation has been a persistent worry, impacting everything from grocery bills to the price of concert tickets. While the annual inflation rate cooled to 2.4% in September 2024, down from a peak of 9.1% in June 2022, it remains a key concern not just for central bankers, but also investors. This is because inflation doesn't just impact our wallets at the checkout counter; it sends ripples through investment portfolios in both obvious and subtle ways.

The most immediate impact of inflation is the erosion of purchasing power. The money you invested yesterday simply doesn't buy as much today. To combat rising inflation, central banks often resort to raising interest rates. This has a ripple effect on both stock and bond markets, as seen in 2022 when both experienced downturns amidst the Federal Reserve's aggressive rate hikes.

Beyond eroding purchasing power and influencing interest rate decisions, inflation also plays a crucial role in determining market valuations. A commonly used rule of thumb suggests that stocks are potentially overvalued if their average price-to-earnings (P/E) ratio surpasses 20 minus the prevailing inflation rate. With an anticipated inflation rate of 3% for 2024, this would suggest a "fair" P/E ratio for the S&P 500 index to be around 17.

Similarly, bond investors closely watch inflation expectations, aiming to secure interest rates that outpace the rate of price increases.

However, the investment landscape isn't solely defined by periods of rising prices. Economists identify five distinct "flation" environments, each carrying unique implications for investors:

Inflation: A healthy economy can tolerate a moderate level of inflation, generally considered to be around 2% or less. However, when inflation surpasses this threshold, alarm bells start ringing. Historically, certain asset classes have demonstrated resilience during periods of high inflation. These include energy stocks, directly-held residential real estate, and Treasury Inflation-Protected Securities (TIPS) – federal IOUs designed to keep pace with inflation. Commodity funds, like the TCW Enhanced Commodity Strategy (TGABX), a member of the Kiplinger 25 list of recommended mutual funds, have also shown strong performance during inflationary cycles.

Disinflation: In contrast to periods of rapidly rising prices, disinflation describes an environment where the rate of inflation is slowing down. This is the scenario currently unfolding in the global economy. Disinflation can actually be beneficial for investors. As inflation cools, businesses often experience improved profitability, which can translate into stock market gains. Growth-oriented companies and bonds purchased during periods of higher inflation can become particularly attractive in a disinflationary environment.

No-flation: This somewhat utopian scenario is characterized by remarkable price stability, with inflation hovering at or below the 2% mark. Such periods tend to be highly favorable for financial assets across the board. The period between 2013 and 2019 exemplifies this phenomenon, where the S&P 500 registered gains for six out of the seven years. No-flation creates an environment where investors are more comfortable taking on risk, leading to strong performance in asset classes like growth and small-cap stocks.

Deflation: Unlike the previous "flation" scenarios, deflation represents a dangerous economic environment. It describes a widespread decline in prices across various goods and services, often signaling a significant economic downturn. Deflation can trigger a vicious cycle of falling wages, job losses, and reduced consumer spending, further depressing prices and exacerbating the economic malaise. During deflationary periods, stock prices tend to plummet, while fixed-rate bonds that offer a guaranteed positive return become more appealing, especially if they were purchased before deflation took hold.

Stagflation: Perhaps the most dreaded of all the "flation" scenarios, stagflation describes an environment where high inflation is coupled with stagnant economic growth and high unemployment. This toxic combination creates a challenging dilemma for businesses. They face pressure to raise prices to offset rising costs but are constrained by weak consumer demand and a sluggish economy. As a result, corporate profits often suffer, leading to poor returns in the stock market. During stagflation, TIPS, with their inflation-adjusted returns, are generally considered the most effective hedge for investors.