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Inflation can affect the stock market. Should I worry about my investments?

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With the unprecedented level of money printing globally in 2020, concerns are mounting that inflation is rapidly rising. But how will it affect the stock market, and do I need to worry about my investments?

Signs that inflation has begun

Between the US Federal Reserve and European Central Bank, accumulated debt has reached an astronomical $16trn, which could grow by another $2.8trn in 2021. That, along with a reluctance to raise interest rates and determination to continue with stimulus, also points to a continued rise in inflation. The effects of low interest rates and continued money printing are pushing up asset prices, including stocks, commodities and house prices.

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The prices of wheat, corn and soybeans have all soared in the past six months and many of us are seeing our weekly grocery bills increasing. Base metals such as copper, zinc and gold are also up. As anyone involved in construction or house renovations will know, the prices of building supplies have likewise rocketed in the past year.

The increase in the cost of these asset classes points to a higher rate of inflation than is being disclosed. That’s not through deceit though. The deflationary effect of lockdowns and a suppressed oil price mean the rate of inflation appears lower than it actually is. As oil prices rise, the real inflation rate will be more apparent. The Bank of England’s current target for inflation is under 2% per year. The 12-month UK inflation rate in November was a very low 0.6%. But with the economy in stop-start mode, we can expect a rise.

Will inflation cause my investments to fall?

As inflation increases, the purchasing power of cash decreases. That’s why keeping money in cash at low/zero interest rates actually causes it to lose value in an inflationary environment. Higher inflation can be welcome news to borrowers because it reduces the real value of debt. And while investing in shares carries risk, it can be a great way to beat inflation. If my investments can realise growth and a return higher than the rate of inflation, then I’ll be quids in.

The point that inflation could have an adverse effect on the financial markets is when it rises above 2%. That would increase pressure on central banks to raise interest rates. Higher interest rates increase the cost of debt, the most obvious being higher mortgage payments. It also discourages spending, which is bad for an economy trying to revive itself. These high interest rates could then cause my investments to lose value.

During a period of high inflation, it makes sense to buy stocks in sectors that can weather the storm. Therefore, I’d consider gold or oil stocks and consumer goods companies such as Unilever or Tesco, which will always be in demand.

Credit crunch 2.0

The current economic situation is reminiscent of the credit crunch in 2008, but not the same. While irresponsible lending caused that situation, we cannot blame the coronavirus crisis on financial missteps. Tackling economic debt causes a conundrum because raising interest rates poses a nightmare for the individuals and businesses that have increased their debt to survive the pandemic.

As a long-term shareholder, I don’t worry too much about short-term inflation fluctuations. However, it’s important to keep a close eye on investments and avoid holding companies with excessive levels of debt.

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Kirsteen has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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