Inflation, which means a rise in the prices of goods and services, is generally considered negative since it decreases the purchasing power of people. Also, higher inflation may lead to an increase in interest rates which further curbs liquidity.
But how does it directly or indirectly affect the stock markets?
First, we must look at how inflation affects the purchasing power of people. As inflation rises, the value of money decreases. For example, if the inflation is 5 percent, the value of ₹100 will decrease to 95 a year later while if it is say 10 percent, the value will decrease further.
Now, since the value falls, so does the purchasing power, you will be able to purchase less with the same amount of money as last year. So there is less money for savings and investments.
Secondly, when inflation picks up, there is a possibility that the Reserve Bank of India may hike interest rates. This in turn will curb the money in the system. If interest rates go up so does the cost of capital which is a combination of debt and equity costs and hence the cash flow of companies diminishes which leads to a fall in stock markets.
However, inflation is not always bad. The decline in stocks is steeper if inflation rises when the economy is contracting since it shows lower profits and revenues, however in the case of an expanding economy, the impact of higher inflation on stock markets can be capped.
Another factor that affects stock markets is that companies raise the prices of their products due to higher raw material prices. Companies that are not able to increase prices due to inflation suffer more since their costs rise more than revenue.
Sectors and stocks
Most stocks are more volatile when inflation is high. Value stocks are better performers during high inflation periods while growth stocks do well in low inflation. Also, high-dividend-paying stock prices generally decline during high inflation as cash flow is affected. Inflation is normally negative for FMCG and consumer durables as people buy lesser products which affect their profits. However one must look at rate-sensitive stocks. Banks may not decline as much as the rise in interest rates by RBI will in turn be reflected in their loan rates which are borne by consumers. Also, generally, IT stocks are not much affected by inflation numbers.
Investment Strategy
Inflation may also prove to be a useful tool in investment. When markets are declining and stocks are cheaper due to higher inflation, it may be a good time for you to add some quality stocks to your portfolio at lower valuations.
Inflation is good in the long run
As mentioned earlier, a rise in inflation when the economy is booming may not be as bad for the equity markets. One must note that GDP growth is not very substantial in years with lower inflation. Inflation is seen as an indicator of GDP growth. Hence, a rise in inflation is viewed to be good for the economy for the longer term and a growing economy is good for stocks. However, a steep rise in inflation, above a certain threshold must be contained or it may lead to bigger problems.