Interest rates and inflation may seem concepts far removed from the
stock markets. But their ability to influence capital flows, so
intrinsic to health of the stock markets, and even affect corporate
performance makes them crucial leading indicators watched by investors.
Even you can track these factors without too much difficulty: Just keep
track of how your bank fixed deposit rates and the Wholesale Price
Index which appears periodically in newspapers varies and you can have
a fair enough idea of where they are headed. A low interest rate regime
and a low inflation rate scenario is an ideal situation from a stock
market investors viewpoint.
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Why does the US Federal Reserve get so much attention…
Coming
back to the markets, whenever there is a change in interest rates or
the reserve requirements of banks, there is an immediate impact on the
market. Based on its view on inflation in the economy, the need to
support industrial growth, the Reserve Bank of India makes adjustments
in the monetary policy. Interest rates and inflation are two of the
most important economic indicators affecting the stock markets
throughout the world.
Interest rates are one of the most
critical determinants of corporate performance. Higher interest rates
adversely impact corporate performance and consequently valuations.
Interest rates determine the borrowing cost of companies both for
funding incremental growth and for expansion. Since the financial risk
of a company increases in a rising interest rate environment, equity
investments become riskier. To give an example, say a company was
earning Rs 130 million as profit before paying interest and its
interest cost was Rs 13 million. Suppose its interest cost was to
increase by 20 per cent, then its profit would be down by Rs 26
million.
Since the risk-return profile of investors undergoes
a change, their expected returns from the stock market and stocks in
particular goes up. The universal logic is that higher the risk returns
too should increase commensurately. Also, rising interest rates means
your fresh investments in income funds and debentures earn more. Hence,
the temptation to shift to debt instruments from equities. Globally,
small changes in interest rates can have a severe impact on capital
flows, as investors shift from one set of instrument to another.
From
an industry perspective, an increase in interest will result in higher
costs. Companies will seek to pass on these costs to users at the risk
of affecting demand. Another threat is consumer demand getting affected
by higher interest rates as loans become expensive. This holds good for
sectors like consumer durables and automobiles where consumer finance
is a key factor. We have seen how interest and inflation rates can
affect the stock markets directly in terms of affecting the risk-return
relationship and indirectly by affecting corporate performance. This
pattern also reveals itself in the form of a measurable linkage between
inflation, interest rates and stock market valuations. |
Inflation
Central Banks worldwide
share a phobia for high inflation rates. They start raising interest
rates when inflationary pressures start building up, that in turn has
an immediate impact on the stock markets. One of the most widely
watched international bodies is the US Federal Reserve, which sets the
tone for global interest rate movements.
Practically, the
relationship between the inflation rate and the stock market follows
the overall economic cycle. The most important determinant, which
affects both the inflation rate and the stock markets is the Broad
Money Supply (represented by M3). Generally, M3 is defined as the total
amount of money supply available in the economy.
It is a well
accepted fact that when M3 increases, the inflation rate also moves up
in the immediate future, since we have a situation of more money
chasing the same amount of goods/services in the economy. Higher M3
also imparts extra liquidity to the stock markets since, the excess
money is channelised into the stock markets, thus pushing up the market
P/E. Hence, stock valuations move up as an immediate reaction to an
increase in M3.
However, a prolonged phase on higher M3 gives
rise to inflationary pressures and has an adverse impact on the economy
in the long-run. Hence, Central Banks, world over consider inflation
(or money supply) as one of the most critical parameters for the
economic health of a nation. Generally Central Banks curtail money
supply (by raising interest rates) to rein in inflation, in the process
reduce liquidity in the stock markets thus adversely affecting stock
valuations.
However, a prolonged phase of lower inflation gives
a boost to the economic health of the nation and the stock markets,
which in turn increases the purchasing power of the consumers, thus
raising the overall consumption levels of the nation. The increase in
consumption translates into higher prices if the nation is not able to
satisfy the increasing demand for goods and services. This again gives
rise to inflationary pressures and the entire economic cycle is
repeated again
Hence, generally the relationship between inflation and the stock markets mimics the economic cycle of the nation. |