Relationship Between Inflation & the Stock Market

The inflation figures  in 2022 across the world have got every economist worried and central banks across the world have increased interest rates. In India too, RBI recently increased the repo rate to 5.90% for the third time in 2022 making the collective increase since May 2022 to 190 basis points. While the world is reeling under the pressure of inflation, the stock markets, on the other hand, although volatile are showing a good picture. So what is the relationship between stocks and inflation? Are they even connected?Read on to know more!

What is inflation?

Inflation is a word that is heard almost every day in TV debates and newspapers. Such is the peril of high inflation that its increase in the UK as a result of some erroneous policies was one of the many reasons that drove the UK PM Liz Truss to resign. Inflation is the erosion of the value of money over a period of time or a reduction in the purchasing power of money. For example, we have all heard from our elders saying they could get so much in Re.1 or Rs.5 but today you hardly get anything. This is the direct result of inflation and the rise in the cost of living that erodes the value of money.

A rise in inflation immediately puts the governments and central banks into action mode to control it and alter their monetary policies to curb it from rising to dangerous levels. But inflation is not always the enemy of an economy. Inflation at healthy levels helps the country to accelerate on the path of growth and increasing economic activities. 

Read More: Tips to make your monthly budget inflation proof

What are the main causes of inflation?

Inflation is present in every economy and is caused by two major factors. These factors are discussed hereunder. 

1. Demand-pull inflation

This is the normal function of demand and supply in the economy which leads to rising prices of goods and services. The demand for goods and services increases considerably in comparison to its supply which leads to a drastic increase in prices due to a shortage in the availability of necessary resources. This was recently viewed in the case of a breakdown of global supply chains when there were severe lockdowns across the globe or in the case of the ongoing war which further led to a shortage in the supply of crude oil and natural gas. 

2. Cost-push inflation

Cost-push inflation is when the prices of goods and services increase due to an increase in the cost of raw materials and other inputs that add to the cost of final products like wages, overheads, etc. The demand for the products does not change which adds to an increase in the final prices of such products. 

How does inflation affect stock markets?

Now that we have seen the meaning of inflation and its causes let us understand how it affects our investments in stock markets. Stock markets have seen a steady increase in the number of retail investors over recent years. These retail investors kind of face a double impact of inflation as they see a rise in their cost of living and also a reduction in the value of their investments to a certain extent. The collective impact of inflation on stock markets is explained hereunder. 

1. Impact on corporates

The direct result of inflation is a rise in the prices of inputs for corporations which impacts the ultimate prices of the final product. Corporates cannot push the entirety of such an increase in the raw materials to the ultimate customers in the short run and therefore this results in a reduction of profits or their bottom line. The reduction of profits further results in reduced stock prices as the confidence of investors may fall down. If a sector as a whole is facing a severe increase in raw material cost, such a sector may face a downtrend for a time period till the impact of inflation cools off. 

2. Impact on consumers

The direct impact of inflation is the reduction in the purchasing power of consumers. Consumers will therefore have less disposable income which reduces their ability to invest in stock markets. With lower participation from retail investors, the demand for stocks will decrease resulting in a general reduction in stock prices. 

3. Impact on equities

When the inflation in a country rises, the central banks usually increase the interest rates in an effort to control the same. The rise in interest levels erodes the liquidity in markets. This results in overall bearish markets and a general reduction in stock prices. In such a scenario, the prices of growth stocks and dividend stocks see a fall in demand. Most investors dump such stocks fearing huge losses but it is ideally a good time to add quality stocks to the portfolio with a long-term investment horizon as in the long term, equity markets have always seen an increase. 

Conclusion

The relationship between inflation and stock markets has to be analyzed with a short-term and a long-term view. In the short term, the direct impact of inflation is the fall of stock markets and there is limited opportunity for investors to make short-term gains as the real returns are negative or negligible. In the long term, the stock market more or less stabilizes and the impact of inflation is reduced. Investors should, therefore, aim for long-term returns while adjusting for inflation in their portfolio and safeguarding their corpus by hedging against inflation through investment in diverse assets like debt funds, bonds, gold, PPF, etc.  

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