How inflation affects Stock markets?

1. What is inflation?

1.1. Inflation

Inflation is the rise in the price of goods and services we use, reducing the consumer's purchasing
power or what a consumer can buy with each currency unit. Inflation refers to the rising price
levels and it is usually measured using the Consumer Price Index (CPI).

1.1. What causes inflation in an economy?

There are two primary causes:

 When demand in an economy is greater than the supply, the price level increases.
However, this is not an overnight thing. When the demand for goods and services
increases, the supply falls short. So, the goods and services are scarce. This in turn impels
the buyers to pay more for the goods and services. Gradually, this becomes a process and
the price level increases permanently for the goods/services.

 The second cause is a rise in the cost of production. Cost of production means the cost of
raw materials, labor, other resources, taxes, and others. When the cost of production
increases there is generally a drop in the production level, which means supply falls. This
in turn creates the scarcity of the goods or services, leading the buyers to pay more and
the price level increases.

2. How inflation affects the stock market?

The stock market is affected by economic factors and inflation is one of the most important ones
amongst all such factors. Stocks could take a hit over the short term because rising interest rates
and higher labor, material, and labor prices prompted companies to absorb those higher costs
before implementing price increases with their suppliers.

The inflation rate in the U.S. continues to surge, with the consumer price index (CPI) published
by the Bureau of Labor Statistics last week rising by 6.2% in October compared to a year ago.
This marks the fastest annual increase in over 30 years and a surge from levels of 5.4% in
September. There are a couple of factors driving rising inflation, including higher energy and
food prices, strong demand and supply chain issues following the Covid-19 opening, and a severe
shortage of workers, which is driving wages higher.

2.1. Purshasing Power

Firstly, the purchasing power of the consumer decreases due to inflation. When the purchasing
power is low, the investors will invest in a fewer number of stocks. This has a direct impact on
the stock market. Supposedly, you had a plan of investing Rs.10000 in the stock market a year
ago. You have accumulated that amount in a year.

However, the inflation in this one year has gone up and it is at present 6%. So, your Rs.10000 is
having a purchasing power of Rs.9400 only. Now, you can buy fewer stocks for Rs.10000. So,
the number of stocks decreases and that impacts the market directly.

The chart below gives a sense of how dramatically inflation can reduce purchasing power.

2.2. Interest Rates

Secondly, the interest rates increase when inflation is on the rise. The government hikes the
interest rate to make the general people save more. This is also for bringing down the excessive
liquidity in the market. However, as the interest rate increases on deposits, it also increases on
the loans. So, the cost of capital increases for the companies, and the value of the equity
decreases. The projected cash flow valuation decreases due to the increase in the cost of capital
which leads to this. So, the stock prices decrease indirectly when inflation rises.

Investors are concerned if inflation stays high, the Fed would have to raise interest rates earlier
than expected (Mozée, 2021).
Higher inflation makes real return lower when an investment has the same nominal return.
Inflation also makes inventories and labor more expensive and could hurt companies’
profitability. Unexpected inflation eats up investors’ returns and leads to lower real returns.
Therefore, investors are constantly trying to forecast future inflation rates so that they would
know their expected real return. Higher interest rates also reduce the present value of their
investments. Therefore, the market sometimes reacts even before the Fed signals its potential
actions.

2.3. Volatility

The stock market becomes very volatile with the increase in inflation. This is since speculation
rises with inflation.

While a part of the investors buys the stock thinking the price to increase in the future, the other
part of investors drops the shares because of the present decrease in profit levels. This creates
massive volatility in the market. The value stocks perform positively when inflation increases.
On the other hand, the growth stocks have an inverse relationship with inflation. If the inflation
increases, growth stocks’ prices decrease.

If you are into the stocks which pay a dividend, then the price can fall for those stocks. This is
because inflation eats up a part of the profit of the company.This leads to less profit and thus less
dividend. Thus, the dividend-paying stocks’ prices decrease.
2.4. Benefits

Finally, there are some benefits of inflation as well, to the stock market and the economy as a
whole.

If the inflation rate is under control that shows the economy is growing. This in turn provides a
good environment for the stock market investors to thrive.

 Banking Stocks: Banks make money off the net interest spread, which is essentially the
difference between interest rates on deposits and interest rates the bank receives from
loans it makes. Now higher inflation typically results in rising interest rates and this, in
turn, can help banks boost their net interest income and earnings. Separately, banks also
stand to benefit from increased credit card spending by consumers. Banks in our theme
include Citigroup (C) and U.S. Bank (USB): – which have a higher exposure to the retail
banking space. Citi stock is up by 26% year-to-date, while U.S. Bancorp is up 28%.
 Insurance stocks: Insurance companies typically invest excess capital from underwriting
to generate interest income. Now higher inflation, which leads to higher interest rates, can
also help boost their profitability. Companies such as The Travelers Companies (TRV)
and Chubb (CB), which are more reliant on investment income compared to peers in the
insurance space, should stand to benefit. Travelers stock is up by about 12% this year,
while Chubb is up 8%.
 Oil and Gas: Energy stocks have a nice track record of performance during periods of
rising consumer prices. While expanding economies should bode well for oil demand and
pricing, big oil companies also have high operating leverage which helps them deliver
higher profit as revenue grows. Picks in our theme include oil and gas bellwether Exxon
Mobil (XOM), which has gained a whopping 43% this year, and Chevron (CVX), which
is up by about 23%.

3. Conclusion

To conclude, we can say that inflation has both positive and negative effects on the stock market.
While the demand-supply imparity and the interest rate rise, make the market slow.

On the other hand, controlled inflation in the economy makes the market grow steadily. This is
dependent on the government, how to use inflation for the betterment of the economy and the
stock market.

Reference:

Impact of Inflation on Stock Market - How it affect Stock Market Investment (top10stockbroker.com)

Stocks That Benefit From Surging Inflation And The Coming Rate Hikes (forbes.com)

Inflation and Its Impact on the Stock Market — EMORY ECONOMICS REVIEW