How Does Inflation Impact The Stock Market?

Stock markets have seen a huge correction across the globe this year. Simultaneously, we have seen inflation spiking across the world so much so that inflation reached a 40-year high in the U.S. at 9.1% and touched 7.01% in India as of June, 2022. We have also seen The U.S. Federal Reserve increase interest rates by 225 basis points (bps) in 2022 alone.

If you’re wondering if these two factors are related, you are right. But the answer to it is not as simple as it sounds and there is a lot more to it. So first let’s understand what inflation is and various types of inflation, before we explore how it impacts equity markets.

What is Inflation and How Does It Work?

Inflation in simplest terms is the sustained rise in overall price levels. For example, if a house was worth INR 1 cr last year and inflation is 7% today, the same house will be worth INR 1.07 cr. As inflation rises further, the same house would cost you even more.

Here are the various types of inflation: 

Demand-Pull Inflation

When we have disposable income in hand, it increases our purchasing power. As a result, demand for products / services increases. When this happens, we see a hike in the prices of the products/services and this, in turn, leads to an increase in the profitability of companies. We call this as Demand-side inflation; it is also known as demand-pull inflation. For example, initially, the demand for disinfectant products grew during the onset of Covid-19 but the supply remained constant. Due to the increased demand, people were willing to pay more and this led to an overall increase in the price of disinfectant products.

Cost-Push Inflation

Inflation also increases when there are disruptions in the supply of products/ services, due to shortages. A concurrent instance of inflation due to supply side shortages is the spike in oil prices due to the war between Russia and Ukraine. Supply constraints and disruption has also resulted in a spurt in the prices of many other goods, like agri-commodities. In this type of inflation, although there is no sudden or significant rise in demand, prices rise due to a relative shortage in the supply. This burden of rising costs of production is either borne by companies or customers. We call this Cost-Push Inflation. 

Coming back to our example, when the recent Russia-Ukraine war posed a threat to a variety of commodities, including crude oil, since Russia exported 11% of the world’s crude oil, production of crude oil was derailed / slowed and supply did not meet the demand. This supply disruption led to an increase in the price of crude oil. This price rise was further passed on to consumers, despite governments efforts to control the price of the crude oil, to a certain extent.

If this higher cost is borne by companies, their profitability or earnings could reduce significantly and this, in turn, would impact their profitability. Since a company’s stock price and long-term returns move in sync with its earnings growth, poor corporate earnings are likely to impact its stock price expectation.

On the flip side, if higher costs are passed on to consumers, it will significantly reduce their disposable income and thus, reduce the funds available to invest. 

What Happens When Inflation Rises?

To compensate for the decrease in purchasing power due to rising inflation, central banks, like the Reserve Bank of India (RBI), typically hike interest rates on deposits and loans. The motive behind this is to incentivize consumers to save more and thereby reduce the excess demand. By increasing interest rates, central banks try to curb excess liquidity in the economy, which might, in turn, reduce inflation.

The demand side inflation can be controlled by central banks while supply side inflation is dependent on the government’s intervention and policies., They do, however, use tools like interest rates, open market operations (i.e., buying and selling of government bonds), etc., to control the supply of money in the economy. 

The RBI, in its quest to control inflation, keeps its focus on detecting early warning signs of any unexpected rise in inflation and takes measures to maintain inflation within its target. Currently, India’s central bank has been seeking to keep retail inflation, as reflected by the Consumer Price Index (CPI), at 4% with a margin of 2% on either side. However, the recent Russian-Ukraine War had led to price rises in global commodities, including crude oil and food, which spiked inflation rapidly above RBI’s 6%, the upper tolerance range, for 6 straight months since the start of 2022. To control the rising inflation, the RBI has hiked interest rates, i.e. the repo rate, by 140 basis points (bps) so far in 2022 with a goal to tighten money supply in the economy.

How Inflation Impacts the Stock Market

We have seen that a rise in inflation drives monetary authorities to raise interest rates. Increases in interest rates result in a shift of assets from equity to debt, as the risk-reward ratio changes. Here’s how: Let’s say a debt instrument previously offered returns of 6% p.a. and is now offering 8% p.a., due to an increase in interest rates. Suppose equity returns remain constant at 15%, the risk-reward ratio has gone down from 2.5 times (15%/6%) to 1.9 times (15%/8%). As the interest rates keep on increasing the risk-reward ratio keeps dropping and this is one of the main reasons why investors shift from equity to debt. 

Due to recent rake hikes, even FIIs have been redeeming a higher amount from Indian Equity Markets. If we consider the last six months, from February 2022 to July 2022, FIIs have redeemed to the tune of INR 1.79 lakh cr whereas in the six months previous to this period, from August 2021 to January 2022, FIIs had redeemed INR 56,588 cr. 

FIIs invest in India to gain from the relatively high returns, despite it being a higher risk market compared to their domestic markets. However, when the rate of interest increases in their countries too, it could prompt them to send funds back home if the risk-return profile appears better there, given that FIIs typically originate from developed markets where the risk is lower than in India. In general too, FIIs tend to repatriate capital when they sense global risks rising. It is for this reason too we have seen BSE S&P Sensex and NIFTY 50 too have fallen 6.79% and 7.14%, respectively, from their respective peaks in October, 2021. 

Now we can relate that due to rising inflation, interest rates have gone up and so the returns on deposits and debt schemes too have jumped. Fixed deposit rates have gone up by 10 bps – 30 bps for different tenures and most banks are now offering between 5.25% and 5.75% for deposits from 1-3 years. Also, the expected returns of company fixed deposits (CFDs), tax-free bonds, government securities, debt mutual funds have also gone up. 

So, you see that as we save more in fixed income avenues, due to the higher interest rates they offer, demand for more risky and potentially high-yielding assets, like stocks, goes down and so does their risk reward ratio. This impacts stock markets adversely. However, it is important to ensure that net real interest rates, i.e., returns earned on an investment after accounting for taxes and inflation, that we earn should be positive. If inflation is higher than interest earned, we should not opt for fixed income products. 

As mentioned before, when inflation is high, interest rates on loans go up, making it more expensive for companies to borrow and spend money. As loans get costlier, the cost of capital (combination of cost of equity and debt) for companies increases. Hence, the projected cash flows are valued lower. Since, the valuation of equity stocks is done by discounting projected cash flows, it will result in lower equity valuations as the discounting rate has gone up. Companies that have a high level of debt suffer the most during this period. 

Bottom Line

The historical trend shows that stock market returns are relatively lower during periods of rising inflation. Well, does this mean that rising inflation is bad for the economy? Not really. Ironically, if we look at history, we can see that on most occasions, rising inflation rates are synonymous with improving Gross Domestic Product (GDP). In fact, very low inflation rates can slow economic growth and the best example of this could be Japan, which is trying to revive its inflation. 

However, rising inflation should remain within defined targets. If inflation is running above targets for a prolonged period, it can create imbalance in the economy. Take for instance, the current state of the economy in Sri Lanka; inflation touched a year-on-year record of 54.6% in June 2022. Moreover, people there are struggling to pay for basic needs, like food, medicine and even fuel and the government’s foreign exchange reserves are at a record low.

So, we can conclude that though rising inflation does have certain downside risks, it is also essential for economic growth. Rising inflation can cause interest rates to go up in tandem. Higher interest rates are most likely accompanied by lower stock market returns and this pretty much explains why the stock markets are currently falling. 

Also, remember the golden saying, “inflation is a silent killer”. So one needs to be ever alert and have the right blend of equity and debt investments.

Leave a Reply

Your email address will not be published. Required fields are marked *