Inflation & Equity Markets

Yogesh Supekar discusses the correlation between inflation and equity returns while highlighting which sectors to focus on during inflationary environment.
 

The interplay between inflation and equity markets is not as straightforward as one would like it to be. In reality, the relation between inflation and equity market returns is much more complex. If consistent inflation is bad for equity market returns, how come the BSE Sensex had a dream run starting in 2003 running up to 2008 till the global financial crisis hit us? BSE Sensex jumped from ~3,300 in January 2003 to ~19,600 levels in January 2008 when the inflation skyrocketed from 3.81 per cent in 2003 to 8.35 per cent in 2008. We can see that the five years of consistent rising inflation saw stock prices almost multiplying in a similar period. [EasyDNNnews:PaidContentStart]

However, when inflation jumped from 8.35 per cent in 2008 to 11.99 per cent in 2010, there was a sharp dip and a consequent recovery in the equity prices. Says Amit Challani, a successful long-term investor: “I think inflation is good for the equity prices. It is very difficult to access as an equity investor as to what level of inflation is optimal for the equity markets. In other words, it is almost impossible to ascertain the exact level of inflation from investors’ point of view as to what starts impacting the aggregate demand in the economy. Investors will always know about it a little late and by that time the stock prices could have already slipped from the top.” 

“That is why it is important to track earnings and listen to the management commentary. I think the management commentary on the impact of rise in raw material prices on profit margins is the key to understanding the inflation on earnings and hence on stock prices, at least when it comes to the manufacturing sector. Honestly, I do not think even the companies are in a position to forecast accurately where the raw material prices are headed to. However, good management is able to more often than not identify the underlying trends in raw material prices and design a risk management strategy to achieve the financial goals and metrics,” he adds. 

“In my experience, an inflationary environment cannot be said to be always bad while at the same time it can definitely increase the volatility in earnings for majority of the companies and hence one needs to be cautious and take a conservative approach when inflation rates are rapidly increasing the way they have done in the past one year,” he further states. Indeed, it will be immature to always conclude that inflation is bad for the markets. That said, one still has to worry about steady inflation levels because beyond a certain level market dynamics inflation can kill economic growth and even worse it can push the economy into a deep recession. The potential hazards of inflation running out of control on economic growth are numerous and painful.
 

India’s wholesale inflation eases to 29 months’ low in March. 

The linkage between inflation and interest rates is well known. With rising inflation comes rising interest rates and that is a big dampener for the earnings’ growth for corporates as we live in a world where the debt to GDP ratio is at an all-time high. With rising cost of debt and debt levels at record highs, the impact can only be negative on the cash flows of the corporates. This increases the default risk and that in turn increases the interest rate as the interest rates are finalised after discounting the default risk as well. It’s a vicious circle that can potentially end in higher defaults in the financial system, higher unemployment, lower economic growth and lower purchasing power amongst the consumers. 

It is also perceived that the risk of inflation is greater when it comes to Small-Caps. And even though Large-Caps are also impacted by inflation, the impact is less severe when compared to the small-caps. The performance of FY23 highlights the underperformance of smallcaps. The Nifty Small-Cap index was down by 28.6 per cent in FY23 while the BSE Sensex remained flat in the similar time period. This period was also marred by rise in inflation. As Arun Chulani, Co-Founder, First Water Capital Fund, puts it, “I believe that the impact of inflation on the small-cap companies will be dependent on the sector that they are in. In general, inflation will be a negative factor, especially for smaller companies for several reasons. To begin with, increase in costs is a major factor. Smaller companies may find it harder to absorb rising raw material costs.

"India witnessed its lowest retail inflation print in the last 15 months at 5.66 per cent versus 6.44 per cent last month, which was just above the RBI’s tolerance level but has now fallen within the tolerance range. This certainly opens the door for the awaited pivot after the current pause. The trend in CPI print should cheer up the already positive D-Street post the surprise pause in the interest rates."

-Umesh Kumar Mehta, CIO, SAMCO MF
 

“This will result in lower margins as well as making it harder for them to be competitive. Larger companies, given their larger demand requirements, will likely be better able to negotiate prices with their suppliers. Smaller companies with more generic products or services will also find it harder to pass on these costs to their customers as their pricing power is likely to be less. Of course, those with more niche products may have a better ability to hike their prices in line with costs. Inflation coupled with rising interest rates and compounded with recessionary fears across the world may make lenders hesitant to lend to smaller businesses and even if they lend, it would be at higher-than-normal rates to compensate for the risk premium. All in all, the impact of inflation on smaller companies is likely to be more pronounced than their larger peer set.” 
 

Finding Focus in an Inflationary Environment 

If we go by the historical performance in the US’ markets, after inflation peaks and begins to normalise a double-digit gain in S and P 500 is what we have seen. Empirical evidence suggests on an average S and P 500 has posted a total return of 13 per cent during the 12 months that followed at least 13 major inflation peaks. Optimistic investors are betting that the interest rates have peaked, meaning that the inflation has peaked in the US while some of the short-sellers believe more rate hikes are on the card, meaning inflation is here to stay much longer than previously expected. 

Without speculating on the direction of price rise, it can help investors to understand which sector has in the past tended to outperform during an inflationary environment. It is perceived that energy stocks do well during rising inflation. Also, defensive sectors such as utilities, consumer staples and healthcare tend to outperform during a high inflationary environment. Banking and financials also have historically performed better with rising inflation. 

In the US’ markets we find that Bank of America, when screened for S and P 500, stocks showed the highest positive correlations to inflation going back to 1975. The other stocks that showed the highest positive correlation with inflation belonged to the metals and mining sector, oil and gas sector and the chemical sector. 

In the Indian markets, if we consider the period from 2017 to 2021 wherein inflation increased from 3.3 per cent to 5.13 per cent, we find that the banking sector stocks and the healthcare sector stocks performed in line with the BSE Sensex while the commodities and IT stocks outperformed the key benchmark index in the similar timeframe. During the period when the inflation peaked and normalised to 4.91 in 2015 from 10.02 in 2013, the automotive stocks and banking stocks along with healthcare stocks outperformed the BSE Sensex while the commodity stocks and the oil and gas stocks underperformed the key benchmark index along with the IT stocks.
 

"The headline CPI inflation has moderated substantially to 5.66 per cent in March 2023 from 6.44 per cent in February 2023, providing some relief to the central bank and the government. While the average inflation for Q4FY23 still stands at 6.21 per cent, the drop of around 80 bps in the March print partly validates the ‘pause’ stance taken by the MPC in the earlier part of the current month. The cooling in the food prices has been instrumental in driving down the inflation levels with the food and beverages inflation sliding down from 6.26 per cent YoY in February 2023 to 5.11 per cent YoY in March 2023. Except for a slight seasonal sequential uptick in fruit and vegetable prices and an upward pressure on milk prices, those in other categories have either declined or remained largely stable. 

The sale of wheat from the buffer stocks in the open market by the government has helped to moderate the prices of cereals, a key factor in pushing up the inflation in the last two months. What will also bring comfort is a meaningful drop in core inflation (excluding food, fuel and light) to 5.95 per cent from 6.23 per cent in the previous month. This is the first time in 18 months that the core inflation has declined below 6 per cent with a modest sequential expansion of 0.27 per cent. If there are no surprises on the weather and the oil front, one can expect the headline inflation to moderate further and settle in the band of 5.0-5.5 per cent over the next few months. Such a trend is likely to support the continuation of the pause although a pivot on rates is still some distance away. "

Suman Chowdhury, Chief Analytical Officer, Acuité Ratings and Research 

Conclusion

To draw any conclusion on correlation between inflation and equity returns can be a tricky task. There is no doubt that consistent inflation creates volatility in the earnings and the negative sentiment can trigger a broad-based sell-off as a risk-off mood can prevail during an inflationary environment. However, reading too much into inflation can lead to poor risk-taking ability and may impact portfolio returns in the long run. If one were to assume that high inflation levels is not good for the equity markets, it will almost be impossible for an investor to participate in the markets when the equity prices are actually cheap and ripe for investments, assuming the market falls owing to steep rise in inflation. 

Every situation is unique and the variables are almost always different. No two peaking of inflation scenarios can be a carbon copy of each other and hence as an investor one has to analyse the situation discounting the current variables rather than looking at the historical correlation between equity returns and the inflation levels. In the current situation which is quite extraordinary in the sense that there is a rapid historic increase in the interest rates in the US, the banking system has become vulnerable and the anxiety amongst the depositors (small banks) is more than the equity investors. Investors must look at inflation and equity markets from a totally fresh perspective given the unique nature of the current market triggers. 

While the global markets will keep guessing about recession and how deep the recession can be, the external slowdown can be expected to have an impact on the Indian economy and markets, albeit the impact is not expected to be severe. The optimistic domestic growth outlook, improving corporate profitability, expansionary government policies and domestic market flows are all expected to support the equity prices in India. FPIs have turned net buyers in April even as the valuations have become less expensive after the current consolidation in the markets. The key risks remain poor monsoon, persistent inflationary pressure leading to higher interest rates, poor economic growth numbers and risk-off sentiment in the markets, negative FPI flows, earnings disappointment viz. Infosys and delay in recovery in the rural sector.

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