Inflation and the stock market

Inflation and the stock market have an interesting relationship. They aren’t directly linked, but the tools that central banks and governments use to control inflation can have an effect on the stock market. 

When inflation goes up, central banks will tend to increase the base rate – as this is the one tool they have to try and bring inflation back down. This then enables high street banks to pass on more interest to their customers – which encourages saving. When this happens, people have less incentive to risk their money in the stock market, because they can achieve steady, certain returns by saving their money in an interest-paying account.

This can cause the market to dip because it reduces demand for investments. But there will always be other factors at play in market dips than just rising interest rates. For example, we’ve had a unique set of circumstances over the last few years, with Russia’s invasion of Ukraine, Liz Truss’s mini-budget, supply shocks in the oil market, and high interest rates – to name a few. These all play into market performance, so don’t think that the market will automatically go down just because interest rates are high to combat inflation. And similarly, don’t assume that when interest rates are low the market will rise.

 

What might happen to inflation next year?

Inflation has been falling for the latter half of 2023, helped in large part due to decades-high interest rate hikes. At the time of writing, the base rate was 5.25%. Inflation on the other hand, was 4.6%. This was the first time in 2023 that interest rates had been higher than inflation – and some consider it to be a turning point in the Bank of England’s mission to get inflation under control.

But is it? Well, what we know is that the Bank of England hopes for inflation to fall to around 3.1% in Q4 2024, and the Chancellor mentioned in the Autumn Statement that the government is hoping to achieve the target inflation rate of 2% by 2025. So, if we take that at face value without accounting for the unknown, then inflation will hopefully continue to fall next year.

This could mean that the base rate might come down from 5.25% too – but this will likely happen very slowly. The Bank of England has already said that there is a risk of inflation persisting for the next few years, so it could be unlikely that it cuts interest rates soon, or at least that it cuts them quickly. And if inflation holds steady at a consistent level for a time, the Bank might even raise interest rates further still.1

But, when interest rates do eventually start to fall, we might expect people to start putting more money into their investments and the stock market – aiming to achieve the higher gains that they’ve become accustomed to with their savings over the course of 2023. More demand for stocks would push share prices higher, which in turn would increase the price of market indices. So, if inflation continues to fall into and throughout 2024 as expected, it will be positive news for stock prices.

 

FTSE 100

The FTSE 100 finished the month up from where it started.2 An overall gain of 1.52% was a welcome change to the previous month. Aerospace and defence stocks lead the way in terms of gains, while automobile and parts stocks were among the biggest drops.

 

S&P 500

Across the pond, the S&P 500 posted gains of 7.79% – its biggest month so far this year.2 There’s been a bit of talk about currency price movements too, particularly as investors have been selling their USD with the bet that US interest rates have reached their peak. We’ll build on this next month, once the picture is a little clearer on whether this bet was right.

Plus, there are elections in both the UK and the US next year – which doesn’t happen very often. The markets could react in a number of ways to the outcome, so next month we’ll also be breaking this down in greater detail.

 

 

1 The Guardian, 20 November 2023

2 Google Finance, 30 November 2023