Investors and businesses need to closely monitor social, political and economic factors that might impact their revenues and profit margins. One such factor is inflation, which can be termed as the gradual increase in the price of goods and services. Inflation increases the cost of living and reduces the purchasing power of a unit of currency.
There are two principal causes of inflation:
- Demand is greater than supply – Scarcity of goods and services makes buyers willing to pay more for them – leading to a general increase in prices.
- Rise in the cost of production – When the cost of raw materials, manpower, etc., rises, the cost of production of goods also rises.
How Does Inflation Affect The Stock Market?
Just like other goods and services, the price of a stock is also affected by its supply and demand. Any social, political or economic condition that affects the purchasing power of the investor could potentially also affect the demand and supply of stocks in the stock market.
The various ways in which inflation affects the stock market are:
- Purchasing power of investors: The purchasing power of investors decreases as inflation increases. With higher inflation, for the same amount of money invested, investors are left with fewer stocks to buy.
- Rise in interest rates: With a rise in inflation, the central bank (Reserve Bank of India) could increase the interest rates, thereby making loans expensive for individuals as well as businesses. When loans get expensive, the cost of capital increases – leading to a lowered value of projected cash flows, resulting in lower equity valuations.
- Volatility in the stock market: An inflationary trend leads to increased speculation on the future prices of goods and services, increasing market volatility. Value stocks (those having strong financials vis-a-vis their stock price) perform better with a rise in inflation. Growth stocks (that are expected to perform over time) have a negative correlation with inflation, and the market price of these stocks could fall when inflation rates rise. In the case of dividend-paying stocks, if the dividend fails to beat inflation, the prices of these stocks could fall, making them less attractive to investors.
- State of the economy: The effect of inflation on stock prices is also influenced by the state of the economy. The negative impact of inflation on stocks is greater in an economy that is contracting/in a recession than when the economy is expanding.
However, inflationary trends need not always spell bad news for the stock market. A gradual rise in the rate of inflation signals growth in the economy. A growing economy means businesses can raise prices and invest in the growth of the business, which in turn leads to job growth. It is only a sudden rise in inflation that erodes purchasing power – negatively impacting the economy.
Together with inflation, many other interconnected factors affect stock prices. During periods of inflation, instead of rushing through with their investment decisions, investors must sift through the economic data, assess the overall health of the economy, assess if the increase in inflation is gradual or sudden, and then take their investment decisions wisely. In fact, there are several asset classes that can perform better in inflationary conditions. Gold or debt instruments like fixed deposits or debt mutual funds can act as a hedge against inflation. Well performing equity funds can also be effective in giving inflation-beating results over a reasonably long period.
Reaching out to a financial advisor can help you invest in stocks that are performing relatively better. This can play a critical role in your larger financial plan to reach your financial goals.