Is the Cost of Living Crisis Dragging Stocks Down?

Businesses in the UK (and indeed across the globe) are facing a turbulent time at present, with this reflected in share price performance throughout indexes such as the FTSE250.

Certainly, British stocks tumbled lower at the beginning of last week, against the backdrop of rampant inflation and a subsequent reduction in the UK’s GDP growth.

Undoubtedly, Brits are trapped in an intensifying cost of living squeeze as we enter the second quarter of 2022. But is this really dragging stock prices and the wider equity market down? Let’s find out!

Addressing the Current Stock Market Performance

The recent decline in UK stocks was borne out across all major indices, with the FTSE100 down 0.7% and the FTSE 250 depreciating by 0.3% during the first week of April.

The headline trigger here was a nominal slump in UK GDP growth, with a 0.3% increase having been projected by economists in a previous Reuters poll. The UK’s GDP also grew by 0.8% in January, but despite these considerations, gross domestic product actually increased by just 0.1% in February.

The reduced rate of GDP was largely attributed to the winding down of the UK’s boost vaccine and Covid-19 test campaigns. After all, these have provided reassurance to investors during the recent uptick in coronavirus cases, while their cessation has undoubtedly weighted on growth throughout February and March.

This trend is expected to continue through Q2 at least, with stock market volatility expected to remain high in an increasingly uncertain economic climate.

The Rising Cost of Living – Is This Dragging Down UK Stocks?

Another reason behind the continuation of this trend lies in the presence of rampant inflation in the UK, which reached a 30-year high of 6.2% in February before peaking at a staggering 7% in March.

Such inflation has emerged following the extensive public borrowing during the coronavirus pandemic on these shores, as part of wider quantitative easing measures aimed at stimulating growth.

In order to facilitate such borrowing, the Bank of England (BoE) slashed the base rate of interest to just 0.1%, creating an underlying risk of rising inflation thanks to the inverse relationship that exists between these two macroeconomic factors.

Of course, a small amount of inflation and consumer price growth is considered to be healthy by economists, especially in the context of encouraging higher rates of more immediate consumer spending.

However, the BoE sets a target inflation cap of 2%, and any increases beyond this mark begin to erode a national currency’s value and the purchasing power of consumers.

It’s the gradual erosion of household purchasing power (and the long-term capacity of inflation to reduce consumer spending and demand for goods) that also contributes to slower economic growth over time, and there’s no doubt that this is a factor in the UK’s recent GDP performance.

A general decline in the demand for goods and services may also be directly responsible for recent fluctuation in share valuations, especially as companies report reduced or negative earnings through Q4 of 2021 and the first quarter of this year.

Even big tech stocks were adversely affected by this trend, with shares in 13 iconic Nasdaq-100 companies (including Netflix, Meta and Adobe) posting losses exceeding 20% during Q1 of 2022.

However, the stocks most affected by inflation were high-growth entities in the mid-cap index, which is down more than 10% overall since the beginning of 2022.

Typically, growth stocks tend to fare worse than value equities during periods of high inflation, as they derive a larger portion of their value from earnings that will occur in the future. So, as long as inflation continues to rise, growth stocks (particularly mid-cap equities) will bear the brunt as 2022 progresses.

Are All Stocks Being Affected?

Interestingly, the decline in high growth mid-cap stocks hasn’t been widely observed in the FTSE 100 to date, with this index having risen by more than 3% in 2022 so far (despite a crash at the beginning of March).

During this period, the FTSE has managed to outpace and outrun its global peers on the back of gains made in the banking and energy sectors, with these entities impervious to rising inflation and having soared following a rally by oil and metal prices in the wake of the war in Ukraine.

However, this trend has begun to change according to the most recent data, with the FTSE 100 down by 27.7 points (or 0.36%) at the beginning of April 19th.

The March hike inflation will be a key contributing factor here, while the widespread cuts in the World Bank’s growth forecasts (which will be followed by a similar move by the even more influential IMF) has also impacted directly on demand and investor sentiment.

At the same time, the UK’s Central Bank has moved to tackle inflation by hiking the base rate of interest in the UK. More specifically, the BoE has increased the base rate three times in the four months between December 2021 and March, from a starting point of 0.1% to 0.75%.

Of course, this is likely to stabilise inflation and achieve its fiscal objective in the medium-term. In the shorter-term, however, this will increase the cost of borrowing for businesses, compounding the issues of decreasing consumer demand and causing things (and earnings) to get worse through Q2 at least.

This will also raise fears of a recession occurring at some point in the second half of 2022, further triggering a flight reaction from investors and particularly risk-averse traders.

The Last Word

On a fundamental level, rising inflation also devalues national currencies, with the British pound (GBP) recently flatlining to $1.3033 against the US dollar (USD) and falling not far from its lowest level against the greenback since November 2020.

Usually, this boosts the FTSE 100 (which features numerous international brands that earn large amounts in dollars), but the climate of slow growth and increasing interest rates is likely to neutralise this potential advantage in the near-term.

The clear takeaway here is that while the rising cost of living is dragging stocks down, it’s not the only factor in play from the perspective of investors. However, it’s arguably the most important, especially when you consider its long-term impact on customer purchasing power and the demand for goods and services.

This is undoubtedly contributing to a challenging stock market environment, and one that’s unlikely to recover fully until Q3 at the earliest.