How Does Inflation Impact The Stock Market?

The way inflation impact the stock market has been one the popular topics of economics and finance. To understand the interaction, first lets lot at how inflation work? and How does it affect price levels of financial markets.

What is inflation? How is it measured?

Simply put, inflation is a rise in prices of several items over a period of time. It is measured through various indices and each provides specific information about the prices of items that it represents. The index could be the Wholesale Price Index (WPI) or the Consumer Price Index (CPI) for specified categories of people like agricultural workers or urban non-manual employees. Each of the indices is created in a specific manner with a certain year as the base year and they consider the price change over a year.

To explain it using an example, if Apples sold at Rs.100 per kilo in 2010, then in an inflating economy, they would cost more in 2020. Let’s say that Apples sell at Rs.200 per kilo in 2020. Therefore, in 2010, you could buy 10kg apples for Rs.1000 but in 2020, your purchasing power will drop and you would be able to buy only 5kg of apples for the same amount.

Let’s look at what causes inflation. There are two primary reasons behind an increase in the inflation rate in an economy:

  1. The first principle on which economics is based, DEMAND AND SUPPLY:
    There comes a point in the economy when people’s income rises leading to an increase in their purchasing power which implies a surge in demand of various goods and services. When that happens supply becomes scarce and prices of goods and services eventually increase.
  2. Increase in the Cost Of PRODUCTION:
    The inflation rate also increases if the cost of production of goods increases due to an increase in the costs of raw materials, manpower, taxes, etc. While this leads to an increase in the cost of production, it also causes a drop in the supply of the said goods. With the demand remaining the same, the price levels tend to increase.

To explain the concept of inflation, let’s take a look at the rising petrol prices,

India is the world’s fourth largest consumer of energy but with low per capita energy consumption. With the ever increasing number of private vehicles, an overall domestic consumption of petrol and petroleum products is on rise in India. There was a registered growth of 5.31% of the same in the year 2017-18 and to meet the increasing demand, the government has to import more and more petrol. If spending of the country as a whole is considered, then 80-90% is done to pay the import bills on petroleum products, which is accounted for as the country’s expenditure. Hence more demand of petrol than supply is a leading factor of its rising price in India.

Now the common man suffers the most because he pays not only the price of crude but also commission of a dealer, VAT, excise duty, total duties and taxes.

Inflation and the Stock Markets

The price of a share in the stock markets is determined by its demand and supply that is affected by a range of factors like social, political, economic, cultural, etc. Anything that affects the investor can have an impact on the demand and supply of stocks and inflation is no different. Here is a quick look at the impact of inflation on stock markets:

1. The purchasing power of investors

Since inflation, by definition, is an increase in the price of goods and services, it also is an indicator of the decreasing value of money. So, if the inflation rate is 5%, then Rs.10,000 today will be worth Rs.9,500 after one year. If the inflation rate increases to 10%, then the same amount would be worth less in the future. Hence, the purchasing power of investors decreases as the inflation rate increases.

This can have a direct impact on the stock market since investors would be able to purchase fewer stocks for the same amount.

2. Interest Rates

When inflation rates increase, the Reserve Bank of India (RBI) increases the interest rates for deposits and loans. The idea is to incentivize people to save money and curb excessive liquidity bringing the inflation rate down. Since loans get costlier too, the cost of capital for companies increases. Hence, the projected cash flows are valued lower, resulting in lower equity valuations.

3. Impact on Stocks

As the inflation rate rises, speculation about the future prices of goods and services leads to a market environment that is highly volatile. Since prices are rising, many investors will speculate that companies will experience a drop in profitability. Hence, some investors might decide to sell the shares leading to a drop in its market price. At the same time, investors optimistic about the company making profits in the future might buy these stocks causing a volatile environment.

Value stocks are strongly impacted by a change in the rate of inflation. The market price of value stocks is usually directly proportional to the rate of inflation. Therefore, when the inflation rate rises, value stocks tend to perform better. On the other hand, Growth stocks have minimal cash flows. Therefore, they have a negative correlation with the rate of inflation. The market price of these stocks drops when inflation rates rise.

Lastly, if you look at dividend-paying stocks, then an increase in the rate of inflation can cause a drop in their market price. This is because, with rising inflation rates, dividends can fail to beat inflation making such stock less attractive to investors.

4. Long-term benefits of rising inflation rates on stock markets

Inflation is not the devil that it is assumed to be. In fact, a controlled rise in inflation rates is a sign of a growing economy. If you turn the pages of history, you will find that on most occasions, a rising inflation rate is synonymous with an improvement in the Gross Domestic Product (GDP). It is important to remember that if the inflation rates are too high, then the purchasing power can erode drastically creating havoc in the economy. However, if the inflation rates are too low, then the growth of the economy can get stunted.

Therefore, investors must compare inflation rates in recent years to assess if the increase is sudden or sustained. If the inflation rates are rising steadily, then it can be healthy for businesses and the economy and be a good environment for stocks.

Summing Up

Long-term investors must consider the fact that the government constantly takes measures to keep inflation in balance. And so, during rising inflation times, investors must avoid panic and emotion-based decisions and look for fundamentally strong stocks that can wither any economic storms with ease.