Impact of inflation on the stock market

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Inflation refers to a gradual increase in the price of goods and services and the consequent increase in the cost of living. This further leads to lower purchasing power. There are a lot of aspects to be considered when we try to assess the impact of inflation on stock market, for e.g.- what causes inflation, is there a relationship between inflation and investment, do people tend to invest less during inflation and how does inflation affect stock indices.

Today investors are well-informed and make decisions based on a thorough study and understanding of the economic cycles. Let us discuss the impact of inflation on the stock markets in detail.

Reasons for rising inflation

  1. Rising cost of production

With the rise in increased cost of production due to an increase in the cost of labour, raw materials, taxes etc., inflation also rises. This increased cost of production leads to decrease in the supply of the said goods while the demand remains the same and thus the price levels tend to increase.

  1. Demand is greater than supply

It may happen that due to the rising income of the people, the demand for products and services increases. During such times, the demand can increase above the supply of the said products and services. This causes a scarcity of goods and services and the buyers have to pay more for such products and services. This eventually results in general increase in prices thereby causing inflation.

Impact of Inflation on Stock market

The price of a share depends on various aspects and is dependent on the demand and supply that is mainly affected by social, political and economic factors. Let us look at each of these points in detail:-

  1. Interest rates and valuations

When the rate of inflation increases, the interest rates for deposits and loans are increased by the Reserve Bank of India (RBI). The main purpose behind this is to encourage people to save money and reduce the excessive liquidity, thereby bringing down the inflation rate. As loans get costlier, the cost of capital for companies also increases. The valuation of equities is done by discounting cash flows. Hence when the rate of discounting goes up, the equity valuations go down.

  1. Purchasing Power of Investors

The purchasing power of investors decreases as the rate of inflation increases. This can have a direct impact on the stock market because investors would be able to purchase fewer stocks for the same amount. 

  1. Impact on Stocks

As inflation rises, a highly volatile market environment is created as there is a lot of speculation about the future prices of goods and services. As prices are rising, many investors speculate that profitability of various companies will also reduce. This leads to many investors deciding to sell their shares, which ultimately leads to a drop in the market price of such shares.

For dividend-paying stocks, an increase in the rate of inflation causes a drop in the market price. This is because with rising inflation rates, dividends can fail to beat the inflation and thus the stocks become less attractive to investors.

Thus, we can say that market stocks are directly proportional to the rate of inflation and when the rate of inflation increases, value stocks tend to perform better. On the other hand, growth stocks have minimal cash flows and therefore they have a negative correlation with the rate of inflation as the market price of these stocks drops when the rate of inflation rises.

Traders and investors must always consider the fact that the government always tries to keep the inflation in check. Moreover, inflation does not cause the havoc it has always been assumed to create. Thus, when the rate of inflation rises, investors must not panic and must not take emotion-based decisions. Also, investors must look for fundamentally strong stocks that generally do not have any impact of economic storms and cycles.

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