How Does Inflation Affect the Stock Market?

Summary:

Inflation is a term that you may have heard a lot in the news. But what exactly is inflation, and how does it affect the stock market? In this blog, we will explain what inflation is, how it is measured, and how it impacts the stock market in different ways.

Have you noticed how the cost of your groceries and essentials, including your daily vegetables, has gone up since last year, or even the year before? That's inflation at work. It's a steady increase in prices that reduces what you can buy with the same amount of money. Inflation affects more than just your shopping bill, it also impacts your savings, the interest rates on loans, and the cost of running a business. But it has a particularly significant impact on the stock market. In this blog, we're going to examine how inflation affects the stock market and why it's important. Let's begin and understand what this means for you and your investments.

How do we measure inflation?

The CPI is the standard method for measuring inflation. To calculate the CPI, we monitor the price changes of a basket of goods and services that people commonly buy, which includes basics like food, clothing, and housing, as well as transport and entertainment. We then express the CPI as a percentage to indicate the degree to which prices have increased or decreased. Take September 2023, for example, when the CPI was reported at 5.02%, a decrease from the 6.83% in August. This indicates that prices weren't rising as swiftly as they were the previous month. It's important to remember that inflation doesn't only go up; it can also come down. This is all cyclical and part of the broader economic pattern. Now, let's turn our attention to how inflation impacts the stock market.

How does inflation impact the stock market?

The stock market is the place where people buy and sell shares of companies. The price of a share reflects the value of the company, which depends on many factors, such as its earnings, growth, and prospects. Inflation can affect the stock market in different ways, depending on how high or low it is, and how it influences the earnings and expectations of companies and investors.

Demand and supply

When inflation hits, the prices you pay for goods and services tend to increase. If you’re a shareholder in a company that produces these goods or services, you might notice an initial profit surge as the company raises prices. However, if inflation keeps climbing, people generally start tightening their belts, buying less and becoming more selective. This reduced demand can result in a decline in the company's revenue, and in turn, its share price might drop. Think about when the price of petrol skyrockets, you might choose to use public transport more often, impacting the revenues of petrol stations.

Purchasing power

As inflation rises, the value of your hard-earned money doesn't stretch as far as it used to. This diminishing purchasing power means you can’t buy as many shares with the same amount of money. Moreover, any returns you’re expecting from your investments need to outpace inflation to truly benefit you. For example, if inflation is at 6.5% and your investments return 4%, you're effectively losing value, not gaining it.

Interest rates and borrowing costs

The Reserve Bank of India (RBI) often combats inflation by raising interest rates. For you, this means if you’re looking to take out a loan or finance a big purchase, it’s going to cost you more. This also affects businesses, as borrowing becomes more expensive, their growth may slow down. Consequently, investors like you might find these companies less appealing, potentially leading to a fall in stock prices. If you have savings in a fixed deposit, higher interest rates might be good news, but not so much if you’re running a business with loans.

Consumer behaviour

Inflation often leads to a shift in spending habits. As everyday items become pricier, you and other consumers might opt for essential goods over luxury items. Companies that sell luxury goods could see a decline in their sales, affecting their stock performance. For instance, if the price of electronics is rising, you might postpone buying that new smartphone, which in turn affects the revenue of electronics companies.

Company profit margins

Companies facing higher costs due to inflation have a tough decision to make: absorb the costs and reduce their profit margins or pass the costs onto consumers and risk losing sales. For example, if a textile manufacturer faces an increase in raw material costs, they have to decide whether to increase the price of their garments, potentially losing customers or to absorb the costs and reduce their profits.

Investor sentiment

The mere expectation of inflation can trigger market reactions. If you and other investors believe inflation will rise, you may start selling off stocks to avoid the anticipated decline in the market, causing stock prices to fall before inflation has even had a chance to directly impact the economy.

Sector-specific effects

Different industries react to inflation in various ways. The financial sector, for example, might benefit from a moderate increase in interest rates. In contrast, consumer discretionary sectors could be hit hard as people cut back on non-essential purchases. If you’ve invested in a diversified portfolio, these sector-specific impacts might balance out, but if your investments are concentrated in one area, you could be more vulnerable to inflation-related shifts.

Guarding your portfolio from the effects of inflation on the stock market

Inflation might quietly nibble at the value of your investments, but it doesn't have to catch you off guard. There are practical steps you can take to protect your portfolio from inflation's impact on the stock market:

• Diversification: Spread your money across different types of investments. If inflation affects one area, your other investments can help keep your portfolio stable.
• Inflation-resistant sectors: Investing in areas like commodities or property can be smart because they often do better when prices go up.
• Floating-rate bonds: These bonds can increase the interest they pay if inflation goes up, which can help your returns keep pace with rising prices.
• Strong companies: Look for businesses that can increase their prices and still keep their customers. These can be good for your portfolio during inflation.
• Regular reviews: Keep an eye on your portfolio and the market to make timely adjustments in response to inflation trends.

The Indian stock market has navigated through many inflationary cycles, and with the right strategies, you can protect your investments too. With careful planning and a diversified approach, you can aim for your investments to grow, even when inflation is on the rise.

Wrapping up: Key points to remember

• Inflation diminishes your purchasing power and profoundly affects the economy.
• The CPI serves as the standard measure for tracking inflation levels.
• Inflation affects the stock market through changes in supply and demand, reduction of purchasing power, alterations in interest rates, and shifts in consumer behaviour.

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