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Impact of Inflation on Stock Market – How Inflation affects Stock Market Investment?

In this article, you will read about the basics of inflation and then we will dig deeper into the impact of inflation on the stock market and the investors.

While estimating the future returns of your investments, you need to make a pace for inflation. If not then your estimate will be flawed.

So, inflation plays a great role in the stock market investments and here in this article, we are going to discuss the same.


What is inflation?

Inflation is a slow and steady rise in the overall price level in an economy. However, there can be a sudden rise in the price level as well which drastically affects the economy and the stock market.

When the price of all goods and services increases gradually, the cost of living increases and the purchasing power decreases. So, all this is known as inflation.


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    What causes inflation in an economy?

    Let us now see the root cause of inflation in any economy. There are two primary causes –

    • When demand in an economy is greater than the supply, the price level increases. However, this is not an overnight thing. When the demand for goods and services increases, the supply falls short. So, the goods and services are scarce. This in turn impels the buyers to pay more for the goods and services. Gradually, this becomes a process and the price level increases permanently for the goods/services.
    • The second cause is a rise in the cost of production. Cost of production means the cost of raw materials, labor, other resources, taxes, and others. When the cost of production increases there is generally a drop in the production level, which means supply falls. This in turn creates the scarcity of the goods or services, leading the buyers to pay more and the price level increases.

    Impact of Stock Market

    Inflation has a great impact on the stock market which we often ignore. While inflation is caused primarily due to demand-supply mismatch, the stock market is also affected by the same.

    The stock market is affected by economic factors and inflation is one of the most important ones amongst all such factors. Let us see how the stock markets and their investors are affected by this phenomenon.

    Purshasing Power

    Firstly, as you read above, the purchasing power of the consumer decreases due to inflation. When the purchasing power is low, the investors will invest in a fewer number of stocks.

    This has a direct impact on the stock market. Supposedly, you had a plan of investing Rs.10000 in the stock market a year ago. You have accumulated that amount in a year.

    However, the inflation in this one year has gone up and it is at present 6%. So, your Rs.10000 is having a purchasing power of Rs.9400 only. Now, you can buy fewer stocks for Rs.10000. So, the number of stocks decreases and that impacts the market directly.

    Interest Rates

    Secondly, the interest rates increase when inflation is on the rise. The government hikes the interest rate to make the general people save more.

    This is also for bringing down the excessive liquidity in the market. However, as the interest rate increases on deposits, it also increases on the loans.

    So, the cost of capital increases for the companies, and the value of the equity decreases.

    The projected cash flow valuation decreases due to the increase in the cost of capital which leads to this. So, the stock prices decrease indirectly when inflation rises.

    Volatility

    The stock market becomes very volatile with the increase in inflation. This is since speculation rises with inflation.

    While a part of the investors buys the stock thinking the price to increase in the future, the other part of investors drops the shares because of the present decrease in profit levels. This creates massive volatility in the market.

    The value stocks perform positively when inflation increases. On the other hand, the growth stocks have an inverse relationship with inflation. If the inflation increases, growth stocks’ prices decrease.

    If you are into the stocks which pay a dividend, then the price can fall for those stocks. This is because inflation eats up a part of the profit of the company.

    This leads to less profit and thus less dividend. Thus, the dividend-paying stocks’ prices decrease.

    Benefits

    Finally, there are some benefits of inflation as well, to the stock market and the economy as a whole.

    If the inflation rate is under control that shows the economy is growing. This in turn provides a good environment for the stock market investors to thrive.


    Impact of Inflation on Stock Market – Conclusion

    To conclude, we can say that inflation has both positive and negative effects on the stock market. While the demand-supply imparity and the interest rate rise, make the market slow.

    On the other hand, controlled inflation in the economy makes the market grow steadily. This is dependent on the government, how to use inflation for the betterment of the economy and the stock market.


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