Inflation Just Smacked the Stock Market Again. What Can Investors Do?

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Friday morning had investors closely watching the latest report on the consumer price index (CPI), as they were hoping to see signs that inflation might finally start to peak. Unfortunately, that didn’t happen, as a 1% rise in the CPI for May brought the year-over-year increase in the index to 8.6%, the highest in more than 40 years. Stock market investors didn’t like that nasty surprise, and futures markets fell sharply after the announcement. As of 9:15 a.m. ET, futures on the Dow Jones Industrial Average (^DJI -2.42%) had fallen 412 points to 31,851. S&P 500 (^GSPC -2.68%) futures had dropped 57 points to 3,959, and Nasdaq Composite (^IXIC -3.21%) futures had lost 204 points to 12,071.

Those moves might not seem all that big, but they came even after nervous investors had already bid down stock prices substantially on Thursday. Given that the bond market has also reacted negatively to inflationary pressures, many investors feel like there’s nothing they can do to protect themselves. However, there are some things to look at in your investment portfolio that can offer a viable strategy over the long run.

The details of the inflationary spike

The latest report from the Bureau of Labor Statistics  revealed many culprits for the rise in prices. The most obvious one for most consumers was energy, as gasoline prices rose 4.1% during the month. Food prices were also notably higher, rising 1.2% between April and May.

Image source: Getty Images.

Food and energy prices are notoriously volatile, so even though it’s not realistic from a household budget standpoint, some economists prefer to focus on other prices. But even the core inflation number that excludes those items rose 0.6% in May, with sizable gains in housing costs, airfares, and new and used vehicles.

Some of the price increases have been truly devastating for consumers. Heating oil prices have more than doubled in the past 12 months, and gasoline has risen by nearly 50%. Food costs are also up double-digit percentages year over year.

Arguably more troubling is that every element that goes into the CPI calculation showed gains that were above the Federal Reserve’s target inflation rate. Even medical care costs, which have stayed largely under control during the inflationary upsurge, were up between 0.3% and 0.4% for the month. The danger that inflation could become an entrenched element of the economy appears to be growing.

What’s the right investment strategy for this market?

It’s been hard to find winning investments in the current market. Most investors look to have a balance of stock and bond holdings in their portfolios, with the thought that the two markets have often moved in opposite directions during past downturns. However, the combination of macroeconomic stresses and higher prices is unusual, and it has resulted in steep losses for bond investors as well as in the stock market.

In the short run, there are clear winners from high inflation. Energy companies are seeing windfall profits as a result of high prices at the pump, with the energy sector being the only one that has seen sizable gains in 2022. Utilities have held their own as well, as they’re largely in a position to pass through higher costs to consumers directly through the regulatory agencies that oversee them.

However, the best thing for investors to do is to think about which investments that are getting hit hard right now are best positioned for a rebound under a range of possible future scenarios. If the Fed is successful in beating down inflation over the next year or two, for instance, then hard-hit growth stocks will eventually see some relief. If the economy falls into a recession, however, then it could prolong the period of lower stock prices in many growth areas. That could make stocks that are currently at low valuations based on traditional measures even more attractive.

Long-term investors whose strategies are geared with the ups and downs of the economic cycle in mind don’t necessarily have to make any changes at all. For them, short-term losses are simply part of the price you pay to reap longer-term rewards over periods of years and decades. That’s not an easy philosophy to have, but it’s one that has worked for a long, long time.