Inflation is a unit to measure the rate at which the value of money changes over time. Since money is the primary medium of exchange that stores value, its purchasing power entirely depends on the price levels. As the prices increase, money loses its value. Therefore, in simple terms, inflation refers to the gradual increase of goods and services prices.
When the prices rise, the cost of living also increases, reducing purchasing power. The same applies to the value stocks in the stock market. When inflation rises, the cost of these stocks also increases, reducing the investor’s purchasing power.
Inflation got you curious? Learn how it works, then explore investing with a opening demat account.
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How Does Inflation Work?
Inflation has a significant impact on stock prices, leading to a highly volatile market environment. As the inflation rate rises, speculation about future prices of goods and services grows, influencing investor behaviour.
Value stocks tend to perform better in high-inflation environments, as their market price is usually directly proportional to the rate of inflation. In contrast, growth stocks, with minimal cash flows, have a negative correlation with inflation and often see their market prices drop when inflation rates rise.
Dividend-paying stocks can also suffer as inflation increases since rising inflation may cause dividends to lose their purchasing power, making such stocks less attractive to investors. This dynamic nature creates a complex interplay between inflation and stock prices, influencing investment strategies and market fluctuations.
How Does Inflation Impact the Stock Market?
Stock market investment has seen a gradual rise in the number of retail investors entering the market. These investors face higher effects of inflation as their cost of living increases and the value of their investments decreases. Below, you will understand the collective impact of inflation on the stock market :
Impact on Companies
Companies face the direct brunt of inflation as the prices of their inputs increase and impact the final cost of the end product. They cannot increase the products’ sale price beyond a certain level, causing a reduction in their profits. Reduced profits further reduce their stock prices as the investors’ confidence in them drops. If the cost of raw materials for a particular industry increases significantly, the sector may face a short-term downfall until the inflation rate cools off.
Impact on Consumers
Consumers’ reduced purchasing power is the direct impact of inflation. As retail investors are left with less disposable income, their ability to invest in the stock markets also reduces. With reduced participation from investors, the demand in the stock market decreases, leading to a significant reduction in stock prices.
Impact on Equities
As inflation in a country rises, the central banks increase the interest rates to gain control. Higher interest rates erode market liquidity, resulting in a bearish condition with reduced stock prices. In such a scenario, most investors sell off their stocks to avoid huge losses. However, it is actually a good time to buy more stocks and build a portfolio. As the inflation subsides, the price of their stocks will increase and produce good returns.
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Impact on the Performance of Value Stocks
When the inflation rates go high, investors start giving preference to value stocks. These shares have higher intrinsic value compared to their current trading rate. These shares usually come from well-established companies with strong cash flows. During high inflation periods, stocks of such companies remain valuable and promise to deliver better long-term returns.
Impact on the Performance of Growth Stocks
Growth stocks tend to drop in price during high inflation conditions. While these stocks do not show strong cash flows and dividend payouts, they have a high potential to outperform in the future. These long-term investment options provide worthwhile returns. However, investors must give them time to grow and show the expected results. If they discount these stocks to a present value, the expected cash flow is still ahead, and the compounded discount adversely affects the current stock price.
Impact on the Performance of Income Stocks
Since income stocks deliver stable and regular dividends, they may fail to keep up during high inflation rate conditions. Their price will reduce until the dividends come back to overcome inflation. International corporations may also experience a reduction in their share prices as the inflation rate increases.
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Impact on Stocks in the Long Run
For investors, stocks provide protection against inflation in the long run. That means the monetary value of their stock portfolio will increase during inflation despite higher prices. If the cause of inflation is the higher input costs, the revenue will increase, and the companies will resume their normal profit rates after adapting to the inflationary pressures. By adjusting their pricing, they can pass on the higher input costs to the consumers. Therefore, having a well-diversified portfolio is more realistic than investing in a particular stock with risk.
Impact on Stocks in the Short Run
Short-term dynamics are less favourable as the relationship between inflation and equity prices is inversely correlated. As inflation rates rise, the stock prices decrease, and vice versa. The following factors might cause adverse effects of inflation on the stock market:
- Falling short-term profits and revenue, creating a drag on stock prices
- An overall economic slowdown, causing an unfavourable environment for the stock market and reducing consumer spending
- Higher short-term interest rates cause investors to find alternate investment avenues
- Negative returns lead to lower demand in the stock market
Conclusion
The inflation rate is the rate at which money loses value over time. A higher inflation rate means increased price levels, reducing the investors’ purchasing power until their income increases. In the long run, company owners pass their higher input costs to the consumers, making a hedge against inflation. Now that you understand the effects of inflation on the stock market, open an online Demat account now and start investing in the right stocks to build a diversified portfolio that provides protection against inflation.
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