How the hike in inflation rates affects stock market returns? #inflation #interest #purchasepower

by Retirement Advisor | Jan 11, 2023 | Invest During Inflation

We have seen that a rise in inflation drives monetary authorities to raise interest rates. Increases in interest rates result in a shift of assets from equity to debt, as the risk-reward ratio changes. Here’s how: Let’s say a debt instrument previously offered returns of 6% p.a. and is now offering 8% p.a., due to an increase in interest rates. Suppose equity returns remain constant at 15%, the risk-reward ratio has gone down from 2.5 times (15%/6%) to 1.9 times (15%/8%). As the interest rates keep on increasing the risk-reward ratio keeps dropping and this is one of the main reasons why investors shift from equity to debt.

Due to recent rake hikes, even FIIs have been redeeming a higher amount from Indian Equity Markets. If we consider the last six months, from February 2022 to July 2022, FIIs have redeemed to the tune of INR 1.79 lakh cr whereas in the six months previous to this period, from August 2021 to January 2022, FIIs had redeemed INR 56,588 cr.

FIIs invest in India to gain from the relatively high returns, despite it being a higher risk market compared to their domestic markets. However, when the rate of interest increases in their countries too, it could prompt them to send funds back home if the risk-return profile appears better there, given that FIIs typically originate from developed markets where the risk is lower than in India. In general too, FIIs tend to repatriate capital when they sense global risks rising. It is for this reason too we have seen BSE S&P Sensex and NIFTY 50 too have fallen 6.79% and 7.14%, respectively, from their respective peaks in October, 2021.

Now we can relate that due to rising inflation, interest rates have gone up and so the returns on deposits and debt schemes too have jumped. Fixed deposit rates have gone up by 10 bps – 30 bps for different tenures and most banks are now offering between 5.25% and 5.75% for deposits from 1-3 years. Also, the expected returns of company fixed deposits (CFDs), tax-free bonds, government securities, debt mutual funds have also gone up.

So, you see that as we save more in fixed income avenues, due to the higher interest rates they offer, demand for more risky and potentially high-yielding assets, like stocks, goes down and so does their risk reward ratio. This impacts stock markets adversely. However, it is important to ensure that net real interest rates, i.e., returns earned on an investment after accounting for taxes and inflation, that we earn should be positive. If inflation is higher than interest earned, we should not opt for fixed income products.

As mentioned before, when inflation is high, interest rates on loans go up, making it more expensive for companies to borrow and spend money. As loans get costlier, the cost of capital (combination of cost of equity and debt) for companies increases. Hence, the projected cash flows are valued lower. Since, the valuation of equity stocks is done by discounting projected cash flows, it will result in lower equity valuations as the discounting rate has gone up. Companies that have a high level of debt suffer the most during this period.

Bottom Line
The historical trend shows that stock market returns are relatively lower during periods of rising inflation. Well, does this mean that rising inflation is bad for the economy? Not really. Ironically, if we look at history, we can see that on most occasions, rising inflation rates are synonymous with improving Gross Domestic Product (GDP). In fact, very low inflation rates can slow economic growth and the best example of this could be Japan, which is trying to revive its inflation.

However, rising inflation should remain within defined targets. If inflation is running above targets for a prolonged period, it can create imbalance in the economy. Take for instance, the current state of the economy in Sri Lanka; inflation touched a year-on-year record of 54.6% in June 2022. Moreover, people there are struggling to pay for basic needs, like food, medicine and even fuel and the government’s foreign exchange reserves are at a record low.

So, we can conclude that though rising inflation does have certain downside risks, it is also essential for economic growth. Rising inflation can cause interest rates to go up in tandem. Higher interest rates are most likely accompanied by lower stock market returns and this pretty much explains why the stock markets are currently falling.

Also, remember the golden saying, “inflation is a silent killer”. So one needs to be ever alert and have the right blend of equity and debt investments….(read more)