Impact of Inflation on Stock Markets: Understanding the Complex Relationship
Stock markets have witnessed significant corrections globally this year, a trend that coincides with a spike in inflation. In the United States, inflation hit a 40-year high of 9.1%, while in India, it touched 7.01 in June 2022. Central banks, like the Federal Reserve, have responded by increasing interest rates substantially. The U.S. Federal Reserve alone raised rates by 225 basis points in 2022. This article delves into the complex relationship between inflation and stock markets, examining the impact of increasing interest rates on investor behavior and equity valuations.
Understanding Inflation and Its Types
Inflation refers to the general increase in prices and fall in the purchasing value of money over time. It can be categorized into several types, including cost-push, demand-pull, and structural inflation. Cost-push inflation occurs when the cost of production increases, leading to higher prices. Demand-pull inflation happens when there is a higher demand for goods and services than the economy can supply, driving prices up. Structural inflation is caused by long-term factors, such as technological advancements and globalization.
How Inflation Impacts Equity Markets
A rise in inflation often prompts monetary authorities to raise interest rates to control the money supply and curb demand. This shift in monetary policy affects the risk-reward ratio, leading to changes in investor behavior. When interest rates increase, the risk-reward ratio for fixed income investments improves, making them more attractive to investors. This shift can be observed in the behavior of foreign institutional investors (FIIs) in emerging markets like India.
Shift from Equity to Fixed Income Investments
As interest rates increase, the risk-reward ratio for debt instruments improves relative to equity. For example, if a debt instrument offered 6% returns and now offers 8% due to higher interest rates, and equity returns remain constant at 15%, the risk-reward ratio shifts from 2.5 (15/6) to 1.9 (15/8). This reduction in the risk-reward ratio encourages investors to shift from equity to debt investments.
Recently, FIIs have been redeeming a higher amount from Indian equity markets. In the six months from February 2022 to July 2022, FIIs redeemed to the tune of INR 1.79 lakh crore, compared to INR 56,588 crore in the previous six months from August 2021 to January 2022. This trend highlights the impact of rising interest rates and inflation on international investors' behavior.
Real Interest Rates and Investor Behavior
Investors should consider the net real interest rate (returns after accounting for taxes and inflation) when making investment decisions. If inflation is higher than the interest earned, it is advisable not to opt for fixed income products. As interest rates rise, investors seek higher returns in fixed income avenues, which reduces the demand for risky assets like stocks, thereby lowering their risk-reward ratio.
Impact on Equity Valuation
The rise in interest rates also impacts the equity valuation. Higher interest rates make borrowing more expensive for companies, increasing the cost of capital. This increases the weighted average cost of capital (WACC), which in turn reduces the present value of future cash flows, leading to lower equity valuations. Companies with high debt levels are particularly impacted as their cost of capital rises more significantly.
Role of Central Banks
Central banks play a crucial role in monetary policy and can mitigate the impact of inflation on equity markets. By carefully managing inflation and interest rates, they can stabilize the economy and reduce the risk of financial instability.
Conclusion
The relationship between inflation and stock markets is complex and multifaceted. While rising inflation and interest rates can lead to significant corrections in stock markets, careful analysis of net real interest rates can help investors make informed decisions. Understanding the dynamics of the market and the role of central banks is essential for navigating these economic challenges.