Currently, Inflation is the buzz word and let us take a look how inflation affects stocks markets and stock prices. To put it in simple words, Inflation is – your money loses purchasing power and as a result you buy less with the money you have than before. When the inflation rates start to rise, investors get very nervous anticipating the potentially negative consequences.
Many industries wait for the response of the Central Bankers or the Reserve Bank of India (RBI) for their measures combating inflation. One of the measures is to increase interest rates, which the RBI is currently doing in its monetary policy.
However, the rising prices and the higher interest rates don’t lead to positive effects on the investment portfolios of investors. When the interest rates are increased it becomes more expensive for the companies to borrow money and their borrowing costs is increased, and expansion plans are slowed down.
Since the revenues and earnings of companies tend to rise at the same pace as inflation, stocks can provide protection to inflation to a significant extent, but only when rising prices can be transferred to consumers. However, if the rising prices are transferred to the consumers this may lead to loss of market share due to competitiveness of companies.
Inflation has another negative impact, namely the prices rise but no additional value is added. Since revenues and earnings of companies rise at the same pace as inflation, their financials are overstated, since no additional value is created. However, when the inflation starts to fall to its normal levels, the overstated earnings and revenues will decline as well. These ups and downs lead to blurring the actual state of value. Hence, we can say that lesser the firm is able to pass the inflation to its consumers lesser is its value and the more it can pass inflation higher is its value.
To conclude, the companies cannot pass whole inflation to consumers due to increase in competition and With the increase in inflation, cost of borrowing is generally increased due to increase in interest rates. As a result companies have to slowdown their expansion plans and their growth is reduced which reduces their valuation. Hence stocks provide a hedge against inflation, only when the company can pass that inflation to the consumers, which inturn would reflect in their earnings.