Bader Al Hussain
PaySpace Magazine Analyst
After the advent of COVID-19, huge and a record number of stimulus packages were disbursed by the respective governments in order to stimulate the drop in economic activity. The lockdown stemming from COVID-19 and the subsequent rebound in the growth of the global economy has resulted in disequilibrium in supply and demand situations in the world.
The inflation rate has a direct and inevitable impact on the financial assets that are traded on the global capital markets. Their performance is impacted, and their intrinsic values change owing to such swings of the inflation rates in the economy.
How will inflation affect stock market? Source: pexels.com
Stock market and inflation
Higher inflation is perceived negatively by stock market participants. The reason behind this is that higher inflation raises the policy rates of central banks, and this in return increases the cost of capital and investment for economic participants. Further, through a rise in cost input
A close observation of literature highlights that inflation creates uncertainty about future rates of return and exacerbates stock market frictions. It could also provide incentives for the government to repress the financial sector to collect inflation tax revenue. However, there are seldom studies that are conducted on understanding the inflation/stock-market relationship. These studies are limited to cross-section comparisons. There is substantial evidence that the variables are cointegrated and bilateral causality exists between them. These findings are consistent with the interpretation that inflation strengthens frictions in the stock market, decreases real rates of return on financial assets, and consequently decreases trading and capitalisation in the stock markets.
The second interpretation of financial sector repression seems valid, because the government collects inflation tax by printing money. Thus, on the basis of results it can be concluded that inflation matters to stock market performance. Therefore, it is neutral and almost obvious that much of the international community’s policy focus should be directed to ensure that finance can make its most effective contribution to economic prosperity through sound, market-driven allocation of saving/investable resources, and policy makers should devise policies to keep inflation in reasonable limits.
“The arguable boom in property values in the UK (the 4th largest stock market) and housebuilder valuations has been fueled by low debt costs with no real certainty as to when a dramatic increase may occur,” comments Ruban Selvanayagam of house sale specialists Property Solvers.
Inflation in the current global economy
The current inflation in the global economy is largely due to two reasons:
- Supply-side inflation
- Demand-pull inflation
The sudden rebound in global economic activity generated a spike in demand for certain essential commodities such as coal, copper, and oil. The prices of these commodities surged to a record level within a small span of time. This invariably increased the cost of production for commodity-based businesses such as steel, energy, and the cement industry. Thus, given uncertainty related to the future trajectory of commodity prices the valuations of stock pertaining to these sectors have gone down. Here it is pertinent to mention that those sector companies have witnessed a sharp fall which have a very high price elasticity of demand. For instance, there is empirical evidence that growth stocks are more likely to underperform when inflation is higher. The reason behind this is that growth stocks have a larger portion of their earnings spread out in the future. And when rates rise, the present value of those prospective earnings is diluted.
Apart from the above, the other reason is that a rise in inflation and interest rates will negatively affect the future profitability and cash flow of the respective entities. “Growth stocks have longer duration than value because they have more of their earnings farther out,” said Larry Swedroe, director of research for Buckingham Strategic Wealth and an authority on stock market history. “If you get rising inflation, you have to discount future earnings.” “Mild inflation is generally good, because it’s a sign the economy is growing, and businesses can raise prices,” Swedroe told me.
Additionally, small-cap stocks that are categorised as growth, are adversely affected as they are more sensitive to rising interest rates. Moreover, stocks with higher dividend yields, such as utilities and REITs, normally witness a dent in their valuations owing to better alternatives in the form of high-yielding government bonds with lower risk. Further, it is pertinent to note that dividends do not increase with the rate of inflation.
Additionally, in the meantime, the freight costs have also been jacked up owing to the surging demand for container space on the ships. This has also contributed to the higher inbound and outbound freight costs for the companies.
However, according to the experts, these supply-driven costs pressures are transient in nature and are therefore expected to taper off in a quarter or so.
Stock market performance and outlook
One of the radical perspectives in this regard pertains to the ongoing power crisis in China. This means that now there will be a yawning gap between the demand and supply of goods from China, resulting in further exacerbation of supply-side issues.
The stock market normally incorporates in its assumptions pertaining to a certain rate of inflation each year and it swiftly adjusts when the expected returns go against the expected inflation.
In addition to that empirical studies have concluded that stocks behave much more negatively to inflation in the event that the economy is in a recession. In contrast the effect of inflation is much more muted when the economy is expanding.
This conclusion is grounded in the economic rationale as when the economy is shrinking, profits and revenues generally drop even without inflationary concerns. When the economy is growing, profits are rising and the economy is aptly able to absorb higher inflation.
There may even be a “sweet spot” for inflation. “When examining S&P 500 returns by decade and adjusting for inflation, the results show the highest real returns occur when inflation is 2% to 3%,” investment analyst Kristina Zucchi wrote in Investopedia.
Stocks may also provide some protection against inflation, Zucchi says. “In theory, stocks should provide some hedge against inflation, because a company’s revenues and profits should grow at the same rate as inflation, after a period of adjustment,” she said.
Inflation only gets worrisome, Swedroe said. “When it moves up so much, the Fed has to act,” he said. “If the market thinks the Fed will tighten when inflation hits, say, 4 percent, the market will begin reacting well before the Fed does anything. The Fed isn’t clear on what level they might act.” So, the market is engaging in a rampant guessing game.
Since the stimulus packages, it is confirmed that the liquidity provided by the Fed has been a primary driver for the performance in stock prices. The Fed tapering is expected to negatively impact the stocks of the companies as this means that less money can now be invested in the markets.
Conclusion
Under the current circumstances, the prospects for technology sector remain sanguine on the back of the following factors:
- The sector has been insulated from global supply-chain disruptions and higher freight costs.
- The recent bearish sentiment in the bourse resulted in attractive valuations of these technology companies.
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