The financial framework in the modern world is highly complex and with the amalgamation of technologies, complexity levels are beyond.
With an abundance of information available to investors and the highly modern penetration of the internet in most rural areas, investor sentiment is now driven by analysis.
On the other hand, data is as opposed to an emotion-driven response.
A classic example of this scenario is inflation.
Traditionally, most people regard inflation as a sign of an unhealthy economy.
However, today, investors are better-informed and understand economic cycles making informed investing decisions at every stage.
In this blog article let’s discuss the impact of inflation on the markets in general and understand rippling effects.
What is Inflation?
In the simplest terms, it is the rise in demand and decrease in supply.
Creating a severe shortage of products in the market.
Also, inflation can be termed as is the gradual rise in the prices of goods and services.
When the inflation rate increases, the immediate effect is witnessed on the cost of living, which increases and leads to a lower purchasing power.
Let’s understand purchasing power first.
Let’s consider an example, if Apples sold at Rs.100 per kilo in 2010, then in an inflating economy, they would cost more.
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.
To take our understanding of inflation a little further, let’s look at what causes inflation.
There are two primary reasons behind an increase in the inflation rate in an economy:
Demand > Supply
There are times when the average income of people in an economy increases and they want to buy more products and services.
During such times, the demand can increase above the supply of the said products/services.
Hence, there is a scarcity of goods and services that causes buyers to pay more for them.
This eventually results in a price rise.
Increase in the cost of production
If the cost of production of goods increases due to shortage of raw material or an increase in the costs of raw materials, manpower, taxes, etc.
It leads to an increase in the cost of production, this also causes a drop in the supply of the said goods.
Amicably, with the demand remaining the same, the price levels tend to increase.
Inflation and the Indian Stock Markets
The price of a share in the stock markets is determined by its demand and supply which 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. Interest Rates
When inflation rates increase, the Reserve Bank of India (RBI) increases the interest rates for deposits and loans.
This is done to incentivize people to save money and tackle the 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.
2. Role of Stocks
As the inflation rate rises, volatility in the market increases.
This encourages mass speculation about the future prices of goods and services.
Since prices are rising, many investors will speculate and have their opinions hooked on to the companies that 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.
And hence the volatility!
Value stocks are strongly impacted by this change in the rate of inflation.
A direct relationship could be drawn between the market price value of stocks 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.
3. 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.
Although we have discussed purchasing power earlier with the apple example let’s dive in for better understanding.
Let’s consider an example that,
The inflation rate is 5%, then the value of Rs.10,000 today will be worth Rs.9,500 after one year (Time value of money).
If the inflation rate still increases to 10%, then the same amount would be worthless 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.
Benefits of rising inflation
Inflation is not the devil that it is assumed to be.
If invested smartly inflation can be a boon for you, your portfolio and the country.
A growing economy is identified by the way its rising inflation rates are controlled.
If you go back in history, you will find that in most circumstances, a rising inflation rate is synonymous with an improvement in the Gross Domestic Product (GDP).
But extreme inflation rates can be harmful!
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.
Hence, long-term investors must consider the fact that the government constantly takes measures to keep inflation in check.
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.
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Hope you enjoyed reading this blog article. Until next time…