How Exactly Does Inflation Affect The Market?
Most of the time, we think of inflation as a bad thing for stock markets. It's not hard to figure out why. When inflation is high, the cost of living goes up and people have less money to spend. When inflation goes up, people earn less in real terms, and when inflation is taken into account, this means that their returns are lower. Second, when inflation goes up, interest rates go up, which also raises the cost of equity. There are also times when the effect of inflation on the stock market is seen as a good thing. So, what does inflation mean for the Indian stock market? Does inflation have anything to do with investments? When inflation goes up, do people tend to invest more or less? Most importantly, how does inflation affect the indices of the stock market, especially the Nifty and the Sensex? Let's look in more depth at each of these points. As one of the biggest share broker companies Zebu has a huge team working to make your trading and investment journey as seamless as possible in our efforts to do that we offer the best trading accounts with lowest brokerage for every trade you make. 1. How inflation affects the amount of money investors can spend What does it mean for prices to go up? Inflation is when the prices of goods and services go up over and over again. In India, the CPI inflation and the WPI inflation are used to measure both retail inflation and producer inflation. Usually, the CPI is a better way to measure consumer inflation because it is more accurate and has more to do with buying power. As inflation goes up, the value of the money you will get in the future goes down. That's what the "present value" of money means. When inflation is 5%, your Rs.100 receivable from a year from now is worth Rs.95 today. When inflation is 10%, your Rs.100 receivable from a year from now is only worth Rs.90 today. With the same amount of money, you can buy less when your purchasing power goes down. This is usually bad for consumer-driven stocks like FMCG and consumer durables because people's ability to pay goes down. This means that these companies will have to lower prices and make less money. 2. Inflation affects interest rates, which in turn affects prices. What happens to bonds and stocks when the inflation rate goes up? Let's start with bonds. When the rate of inflation goes up, so do interest rates or bond yields. We've seen this happen in the last six months, when inflation expectations have gone up and bond yields have gone up sharply by 125 basis points. So that the Yield To Maturity or total rate of return of these bonds stays about the same, when bond yields go up, bond prices will go down. When the price of a bond goes down, people who own bonds, like banks and people with mutual funds, lose money. This is why banks tend to lose money when interest rates go up. How about stocks? When both inflation and interest rates go up, the cost of capital goes up as well. The cost of capital is the sum of the costs of equity and debt. And when bond yields go up, the cost of running a business goes up. This means that the company's future cash flows will be worth less. We know that future cash flows are taken into account when figuring out how much a stock is worth. When the rate of discounting goes up, it makes sense that the value of an equity will go down. In a strange way, higher inflation is good for stocks in the medium to long term. Even though inflation may be bad for bonds and stocks in theory, we can't forget that it also has a good side. Usually, rising inflation means that GDP growth is getting better. Even in the US and Japan, the big economic battle is all about getting inflation back to the 2% level. That is thought to be the level where growth will start to happen. In fact, if you look at the growth of the world and even India over the last 20 years, the GDP has never grown significantly when inflation was low. Even though ridiculously high inflation can make it hard to buy things, a certain level of inflation is needed to encourage businesses and producers. So the real problem is inflation which gets too high. At Zebu, we have a huge team working to make your trading and investment journey as seamless as possible in our efforts to do that, we offer the best trading accounts with lowest brokerage for every trade you make.