Inflation is feared by democratic governments worldwide as rising prices serve as a red flag to voters. Bond bulls hate it too as rising yields lead to capital losses. But how do investors in stocks perceive inflation?
I read an article recently which contained a comment that the performance of the BSE 500 was inversely proportional to the rate of inflation. This is counter-intuitive to some extent. If lower inflation is good for stocks, then Japan (and possibly, the USA today), which is experiencing deflation should have had the best-performing market. Similarly, India, which has had double digit inflation for a year now, should have been at a yearly low.
There is no “black-and-white” answer to this seeming contradiction. It depends on the stage of the economic cycle, constituents of inflation, the time period under consideration, etc.
In the Indian context, commodity producers and extractors comprise around 30% of the profits of the index constituents. A rise in the global price of metals and similar basic materials cause an increase in the pricing power of these companies and thereby bolster the earnings and stock performance.
Also, at the beginning of an economic upturn, inflation may appear to be high because of the base effect. Higher inflation will therefore not result in reduced demand. Again, loose monetary policy during the tough times will actually end up increasing the consumers’ ability to pay for goods and services, thereby leading to an element of demand-pull inflation too.
As time passes, the salutory effects of inflation fade away, especially when it percolates down to essentials and food items. It is here that consumers start to reassess their consumption basket and start resisting price hikes. Here the companies’ pricing power begins to taper off and earnings start flattening out. Parellelly, the central bank too starts hiking interest rates in order to curtail the “demand-pull” side. So markets too start to flag...
Deflation is a phenomenon comprising falling prices, job insecurity and consequent lack of aggregate demand. Companies find it very difficult to raise prices in such a case. Hence consumers have an upper hand over shareholders. Japan is currently the best example of such a market. Over longer time periods, it has been observed that moderate inflation does not gag demand and often serves as an incentive to innovate. In India, the RBI has targeted a rate of around 5-6% inflation for this fiscal. Currently we are way above it but there are hopes that it will temper down, going ahead.
I guess the Spice Girls got it right when they sang “Too much of something is bad enough/Too much of nothing is just as tough...”
The original article could be seen here.