The hidden relationship

Inflation and the stock market- A hidden relationship 

What is Inflation? Inflation refers to the rise in the prices of goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. This rise in the price of goods is due to many micro and macro factors such as increased production costs and a rise in demand for products. Macro factors such as economic policies (e.g., expansionary monetary policy) that lead to lower interest rates, tax cuts, etc. 

To get a better idea of inflation and why it's called the silent killer, let us take an example of a sum of Rs 1,00,000 kept aside as ‘savings’ in the bank, without any interest. Over 20 years, taking India’s average inflation over the past 20 years (i.e., 6%), the Rs 1,00,000 kept aside in the year 2000 would now (in 2020) be worth approximately Rs 25,000. A colossal loss of Rs 75,000 to the savings kept in the bank. Well, you will still have Rs 1,00,000 in currency (notes and coins) but the 1,00,000 will now be worth Rs 25,000. Not really a loss, what this means is that the buying capacity of the 1 lakh (100 thousand) kept aside would now be only 25,000. Meaning, in 2000 you could buy 1 lakh candies (Rs 1/candy) but in 2020 you could only buy 25,000 of them.

Inflation is not all bleak, a low to moderate inflation has its advantages. In fact, in some situations countries tend to bring out policies to increase inflation. Here’s why inflation can also be good:

• Moderate inflation leads to economic growth.
• Inflation is better than deflation (fall of prices)
• Inflation allows adjustment of prices and real wages.

 

 

INDIA AND INFLATION:

Before relating the stock market and its response to inflation, finding out the ideal inflation for a country like India is necessary. As a growing economy and a developing country, the ideal inflation rate for India should be around 4-5%. Although the ideal inflation rate for any country is set at 2-3% by economists, nations such as India, Brazil, Indonesia, which are developing tend to have an average of 6-7% of inflation rate in the last 15 years.

When compared to its peers, 5.5-7% is an ideal rate for a country such as India. Since the past 15 years (2005-2019) India has maintained an average of 7% of Inflation which is on the higher side of the required amount. But, this can be due to the various macro factors that came into play such as the 2009 financial crisis, expansionary monetary policy in the late 1990s, and supply shocks. All of which contributed to the high inflation rates over the years.

Although India’s inflation rate is on the higher side, it still has not touched the amount where it impedes the country's economic growth.  

INFLATION AND THE STOCK MARKET:

The broad outlook among the financial sector is that inflation is good for stock prices and the stock market. But a high inflation rate is invariably considered deleterious for the economy. The high inflation rate influences various other factors such as reduced standard of living (due to decrease in buying power), increase in borrowing costs, increased input costs (labor, wages), and further relates to decreasing company earnings. Consequently, putting pressure on company estimates and its stock price.

An unexpected rise in inflation is also taken poorly by the stock market. Usually, investors and traders are prepared for a certain amount of inflation (even during times of high rate they tend to estimate inflation rise and adapt accordingly). An unexpected rise in inflation has a fearful impact on the stock market. This leads to minor or major corrections in the market and hence leads to the market underperforming. This leads to minor or major corrections

BSE Sensex (1997-2021):

As seen in the chart, there have been a few instances of inflation-related changes in the stock market. Granted the stock market does not go up or down due to inflation, various other factors add to its continuous rise and fall.

Although this should not be perceived as a trading strategy, market predictions can be made by looking at inflation rates. Fisheye's view of the market and inflation shows that high inflation rates are generally times when the market has underperformed. This should be understood: the market underperforming is not due to inflation, but the impact inflation has on the companies, leading to the market underperforming. When inflation increases, the stock market tends to underperform and undergo losses and corrections. By contrast, a period of low inflation (under 6%) has shown constant gains in the stock market, outperforming estimates.

Therefore, while looking at the broader picture, a relation between inflation and the stock market can be derived.

CONCLUSION:

Inflation and the stock market may not have a direct relation, an indirect relationship is present between the two. It is not so much that inflation may be the reason why the market might perform in a certain way, but how inflation impacts the country’s economy, further impacting businesses. There are hundreds of other factors such as interest rates, gold prices, budget allocation, and various micro factors which affect the stock market. 

Although inflation, solely, should never be used to predict the stock market, it should be researched upon, along with other macro and micro factors. All in all, all these indicators are just a tool to predict and guess how the market will behave, it can never truly be a certainty.

*the above-mentioned steps and companies are not investment advice*