We normally tend to equate inflation as a negative trigger for equity markets. The reasons are not far to seek. Higher inflation means higher cost of living and therefore lower purchasing power. When inflation goes up, people earn less in real terms and that result in lower returns net of inflation. Secondly, higher inflation means higher rates of interest and that also impacts the cost of equity. We shall look at this point more elaborately in the ensuring paragraphs. There also times when the inflation impact is seen as positive for the equity markets.
So what is the impact of inflation on Indian stock market? Is there a relationship between inflation and investment? Do people tend to invest more when inflation is up or do they invest less? Above all, how does inflation affect the stock market indices; especially the Nifty and the Sensex? Let us look at each of these points in detail..
1. How inflation impacts the purchasing power of investors
What do we understand by inflation? Inflation is the systematic rise in prices of goods and services. In India the retail inflation is measured by CPI inflation as well as the producer inflation which is called the WPI inflation. Normally, the CPI is a more accurate measure of consumer inflation and is more relevant to purchasing power. Let us understand this with an example..
Particulars5% Inflation7% Inflation10% InflationAmount at the end of 1 yearRs.100Rs.100Rs.100Inflation adjustment factor0.950.930.90Value of Rs.100 in today’s termsRs.95Rs.93Rs.90
As can be seen from the above table, as the inflation rises the present value of the money that you will receive in future actually goes down. That is what is called the present value of money. When the inflation is 5%, then your Rs.100 receivable 1 year later is worth Rs.95 today whereas when the inflation goes up to 10% then the Rs.100 receivable after 1 year is worth only Rs.90 today. When your purchasing power goes down you are able to purchase less with the same amount of money. This is normally negative for consumer driven stocks like FMCG, consumer durables as people’s ability to pay goes down and therefore these companies will be forced to cut prices and reduce their profits.
2. Inflation impacts interest rates and that impacts valuations
When inflation goes up what happens to bonds and to equities? Let us look at bonds first. When the inflation rate goes up the interest rates or the bond yields will also go up in tandem with the inflation. We have seen that phenomenon play out in the last 6 months when the bond yields have gone up sharply by 125 basis points in tandem with the rise in inflation expectations. When bond yields go up the bond prices will go down to ensure that the YTM of these bonds remains at around the same level. When bond prices fall, it leads to capital losses for bond holders like banks and people who have mutual funds investment. That is why rising interest rates is normally negative for banks.
What about equities? When inflation goes up and the interest rates also go up, the cost of capital will also go up. Cost of capital is a combination of cost of equity and the cost of debt. When the bond yields go up the cost of capital goes up and therefore the future cash flows of the company will be valued lower. We know that the valuation of equities is done by discounting future cash flows. When the rate of discounting goes up obviously equity valuations go down.
3. Ironically, equities benefit from higher inflation in the medium to long run
While theoretically inflation may be negative for bonds and equities, we must not forget a positive aspect of rising inflation. Normally, rising inflation is synonymous with improved growth in GDP. If you look at the last 1 year from the beginning of 2017, inflation has been on an uptick. During the same period, the GDP growth has shown signs of bottoming out, the corporate results have shown green shoots of recovery and the stock market indices are up by over 20% during the year. The positive takeaway from inflation is that it is an indicator of GDP growth. Even in the US and Japan, the big economic battle is all about reviving inflation back to the 2% level. That is supposed to be the cut-off level which will spur growth. In fact, if you look at world growth and even at India’s growth in the last 20 years, GDP has never grown substantially when the inflation was low. While obscenely high inflation can play havoc with purchasing power, certain threshold inflation is required to incentivize producers and businesses.
So inflation, beyond an acceptable limit is the real problem. Rising inflation has certain downside risks but it is also essential for growth. It is this balance that holds the macroeconomic key.