What happens to stocks after an inflation shock?

I don’t know why but something inside me thinks we might be in for another inflation shock. Time then to repeat how stocks react to a sudden increase in inflation so we have a reference point we can go back to if needed.

Benjamin Knox and Yannick Timmer did a nice analysis of how investors react to inflation surprises and inflation shocks. Note that they focus on how investors perceive inflation shocks and how they react to them by buying or selling shares, not necessarily how inflation shocks work their way through a business. In the end, it doesn’t matter (in the short run) whether a business can digest inflation well or not. If investors think inflation is a cost to a business, they will sell the shares until the price reflects investors’ assumptions about how inflation will impact the business.

The chart below summarises what happens to share prices in the ten trading days (two weeks) after an inflation shock. On average, the real share price drops about 4% in reaction to a 1% inflation shock. Of course, if inflation rises, the nominal share price will drop less than that but then again, shares are supposed to be inflation hedges, aren’t they? As I mentioned before, shares aren’t inflation hedges, at least not when it matters most and inflation is high.

Decomposition of real stock returns after an inflation shock

Source: Knox and Timmer (2024)

The reason why share prices drop (in real terms) after an inflation shock is twofold. The chart shows that the equity risk premium increases because investors are less certain about future profits. The result is a decline in share prices (blue bars). This uncertainty is compounded by investors reducing their future (real) cash flow assumptions since they perceive inflation as a cost that doesn’t increase revenues as much as it increases costs (red bars).

On the other hand, an inflation shock triggers lower real yields on bonds as investors expect the economy overall to slow down. This reduces the discount rate for future cash flows and increases the net present value of future profits and thus share prices (green bars). Unfortunately, in most cases, this discount effect is much smaller than the expected impact on cash flows and risk premia so the net effect is negative.

However, not all stocks are equally sensitive to inflation shocks. The second chart of today shows that in an inflationary environment, one needs to focus on companies with market power. Companies that can charge high markups on their products and services (which lead to high operating margins) are much better able to digest a cost shock from unanticipated inflation than stocks with low markups. The difference between the top 25% of companies by markup and the bottom 25% is substantial as the chart below shows. Low markup companies drop about twice as much in reaction to an inflation shock than high markup companies.

In summary then, if you want to prepare for an inflation shock, you should look for companies with high markups and operating margins as well as high equity risk premia (i.e. a high margin of safety). In the language of factor investing, you should look for quality value stocks.

Stock returns around inflationary news by market power

Source: Knox and Timmer (2024)