Inflation and its connection to the performance of the stock market

Introduction

Inflation can be defined as the persistent increase in price level over a certain time. Inflation assesses how much more costly a particular set of products or goods and also services in a country has become over a certain time period, usually a year. When there is an increase in the overall price levels, according to the theory of inflation this price level increase is stated as a percentage which signifies that the purchasing capability of a currency has decreased than previous time period.

In the economy of a nation inflation is a situation when aggregate price levels of goods and services rise continuously. This continuous price increase undermines the purchasing power of the domestic currency of that country. Other financial assets that have a fixed value are also affected. As a result, uncertainty and distortion occurs in the economy. A rising inflation negatively affects every single area of an economy. Inflation and the stock market are inextricably linked. Inflation will have a direct or indirect influence on all industries. But the stock markets are the worst sufferers when there is inflation in the economy.

When there is high inflation rate in an economy interest rate is also elevated. With a higher inflation and higher interest rate the creditor will attempt to compensate for the interest rate increase. Consequently, the debtor is left with a very little option but to take out a loan at high interest rate. This is a major factor that plays a vital role in preventing funds from being invested in the stock market. An unplanned and sudden surge in inflation will lead stock markets to plummet. Inflationary pressures would very certainly increase the likelihood of interest rate hikes. Profitability and economic growth will be harmed because of this.

In the year 1920 there was hyperinflation in Germany. At that time instead of holding cash people invested in stocks. As a result, share prices increased a lot. The reason behind this was that stocks gave people the opportunity to invest in companies that had both assets and capital. In this way some real value of money was secured. People who put their money in banks were worse off because bank money became worthless because of the inflation. Individuals who held physical assets, such as land, factories, and equipment, were able to keep their riches since assets were immune to inflation’s effects.

 

Literature Review

Imran (2016) states that stock market performances are affected by the micro and macro factors. One of the most significant macroeconomic factors is inflation that influences the performance of the stock market. This influence of inflation on stock market can be either negative or positive. Every sector of an economy is affected indirectly or directly by this macroeconomic factor inflation. In tandem with the nominal interest rate when inflation rises the cost of borrowing rises as well. As a result, stock prices and net profit both will decrease because of the high cost of borrowing.

(Timothy) stated that the relationship between  stock prices and inflation is inversely correlated. Stock prices fall when the inflation increases. On the other hand, stock prices increase when inflation fall. He states that inflation’s short-term negative impact on stock prices might be caused by a variety of reasons. First of all, inflation causes fall in profits and short-term revenues which create a slog on share prices. In general, the economy slows down. Inflation is also the consequence of an unfavorable macroeconomic condition for consumer spending and for the stock market. Furthermore, in response of the if the inflation if a monetary policy effects higher short-term interest rates it will be the reason that investors will start substituting stocks for lower priced bonds. In an economy where there is inflation the investors need to make sure of the fact, they receive a higher return from a stock portfolio so that the investor can ensure a positive real return.

Hanan A.D Al-Abbadi and Shatha Abdul-Khaliq (2017) did a study on what connection inflation has with stock market performance in Jordan. In their study they came up with a result that it is possible that in the long run stocks can beat inflation. As an example, they stated that Because of inflation both the wages and cost of sales rises. In response to that companies raise their prices and pass this increased cost to consumers. With an increased price earnings and revenues of the company also increases. When earning increases valuation also increases. This eventually leads to increased stock prices. This way companies can response to inflation. But it becomes difficult for the companies that compete with other foreign companies in the global market. Because foreign companies or producers won’t be affected by the inflation, and they don’t need to increase the prices of their products. Inflation robs everyone in an economy. Prices increase but corresponding to that value does not increase. Consumers pay more for less than before. However, in the long run stocks are a good hedge against inflation.

Modigliani and Cohn (1979) sates that money illusion is the main reason behind the real effect of inflation. The investors of stock market are the sufferers of money illusion. They use nominal discount rates to discount real cash flows, and this will end up causing behavioral problems which consequences in inflation-induced valuation errors. The Modigliani-Cohn hypothesis also assumes that when there is high inflation in the economy the stock market will become undervalued. Because it is assumed that once actual nominal cash flows are exposed the undervaluation will be removed.

Alexakis et al. (1996) volatility in inflation rates is the main reason that high inflation rate affects the stock prices. These volatility in inflation rates mainly exist in economies that has emerging capital markets. On the other hand, economies that consist of developed capital market have stability in stock prices and have low inflation rates. Several empirical evidence gives the proof that inflation rate negatively affects the emerging capital markets.

Fisher (1930) sates nominal stock returns are hedge against inflation therefore when there is an increase in expected and current inflation there is also an increase expected nominal dividend payments. But Gordon (1959) claims that discount rate needs to be regulated by the rate of return that an investor expect to get as capital yield or dividend yield on the stock. Consequently, the expected flow of future nominal dividend payments for stock increases when there is an increase actual inflation rates and inflation expectations. Stock prices go upward.

Lintner (1975) and Donald (1975) stated that equity prices and real output has a negative relationship with inflation. Companies tries to raise external financing when there is increase in inflation rate. As a result, real cost of capital of the company increases. Optimal rate of real growth will be reduced because of this increase even if the company maintain profit margin and demand of product keeps continuing to expand at the same rate.

 

 

Methodology

*No Inflation Condition

τ = corporate income tax rate

θ = personal income tax rate

q = share price that an individual would be willing to pay

ρ = marginal product of capital

δ = risk on specific stock

r = interest rate on Treasury bill

According to Feldstein (1980) in the economy when there is no inflation an investor’s income is subtracted by personal income tax. This is the earning of the investor.

*Positive inflation condition

In the economy when there is an persistent rise of inflation, the companies will earn[(1-τ)ρ -λπ], Here ,π is denoted as the inflation rate and λ is the units of net corporate profit which is abridged by a one percent increase in inflation. After deducting the personal income tax what an investor get is (1-θ) [(1-τ) ρ – λπ]

Considering tax on capital gain an investor will be subject to capital gains tax only when he or she sells shares. Here, c is denoted as the tax rate on capital gain. Inflation influences the price of share. As a result, πq is the new share price. And cπq is the capital gain after tax. However, individual get (1-θ) [(1-τ) ρ – λπ] – cπq

*Fisher Hypothesis

The fisher hypothesis formulates the connection between inflation and stock return as:

t, k= t, k\It-k) + t, k…………………… (3)

α = expected real rate of stock returns

β = coefficient of nominal return on expected inflation and on common stock; according to Fisher hypothesis, β = 1

E (πt, k \It-k) = expected inflation rate from time t-k to t

And if in case expected inflation is unavailable then actual inflation rate replace the model. Then it becomes:

Rt, k=α+β t, k+ t, k………………………… (4)

In equation number 4, t, k is denoted as the residual, and it equals to t, k\It-k)- t, k+ t, k

The coefficient of nominal stock returns on inflation is 1 and it is invested in common stocks hedge against inflation is what claimed by the fisher hypothesis. But other economists Alagidede (2009) observed empirical findings and stated that the correlation that exist between inflation and stock return is varies from time to time. Common stock can be used as a hedge against inflation by an investor in the long run. But in the short run it is not at all effective.

To represent the relationship between inflation and stock market performance the econometric equation can be written as:

ln (SP) = 𝛽0 + 𝛽 1ln (IR) + 𝜀

In the above equation inflation rate is the explanatory variable and stock performance is the dependent variable.

Vector autoregressive model can be used test the relationship between variables. Because with VAR model separate equations can be estimated very easily. The standard form of VAR model is:

y 0+ 1yt-1+ 2zt-1+

 

Conclusion:

The relationship between inflation and stock market performance is a very important economic factor. Some economic scholar stated that the connection that exist between inflation and stock market is at some extent positive, but most of the scholars agreed to the point that there is negative relationship between inflation and stock market performance. So, with taking the help of monetary policy inflation rate needs to be reduced so that international and local both the investors feel more confident to invest.

 

References:

1) Imran Ramzan (1st November,2016) “Impact of Inflation on Stock Market Performance in Pakistan’

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3425133

2) Timothy Joubert ‘How does inflation affect the stock market?’

https://www.ig.com/en/trading-strategies/how-does-inflation-affect-the-stock-market-210423

3) Doug Ewing (15th March 2022) ‘How does inflation affect the stock market and potential strategies to take with your clients’

https://blog.nationwidefinancial.com/markets-economy/economic-commentary/how-inflation-affects-the-stock-market/

4) Modigliani, F. and Cohn, R.A. (1979), “Inflation, rational valuation, and the market Financial Analysts Journal’, Vol. 35 No. 2, pp. 24-44.

5) Fisher, I. (1930), ‘The Theory of Interest’, MacMillan, New York, NY.

6) Alexakis, P., Apergis, N. and Xanthak, E. (1996), ‘Inflation volatility and stock prices’: evidence from ARCH effects, International Advances in Economic Research, Vol. 2 No. 2, pp. 101-111.

7) Lintner, J. (1975), ‘Inflation and security returns’, The Journal of Finance, Vol. 30 No. 2, pp. 259-280.

8) Kullaporn Limpanithiwat and Lalita Rungsombudpornkul (2010) ‘Relationship between Inflation and Stock Prices in Thailand’

9) Hanan A.D Al-Abbadi1 and Shatha Abdul-Khaliq (2017) ‘The Relationship between Inflation and Stock Market Performance in Jordan’ European Journal of Business and Management Vol.9, No.29

 

Note: This article was submitted to Professor Farzana Munshi of Brac University of Bangladesh as a part of the writer’s course study.

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