Should equity investors be worried about high inflation? What does the past indicate?

Consumer inflation is at a high across the world. It reached a 40-year high in the US at 8.6%, while in India, it touched 7 per cent in May. Since the Russian invasion of Ukraine, global oil and food prices have increased, stoking inflation in many countries.

In its quest to bring down inflation, the US Federal Reserve recently increased rates by 75 basis points. RBI, on the other hand, hiked the repo rate by  90 basis points over two FOMC meetings. 

High inflation is not a new phenomenon in India. Inflation had touched double digits many times in the past. The big question is whether it has impacted the returns for the stock market investors? 

Inflation and equity markets

Higher inflation affects corporate earnings in many ways. For instance, it reduces consumer spending power. Secondly, high-interest rates that usually go in tandem with persistently high inflation rates affect corporate profitability while making goods less affordable to consumers. 

Since market index returns over the long-term move in sync with growth in earnings of its constituent companies, poor corporate earnings impact equity return.

Historical relationship

The best way to determine the relationship between high inflation and stock market returns is to look at its movements over several market cycles. 

Let’s assume that an average (annual) consumer inflation of 7% p.a. or more for at least five years is a period of ‘high’ inflation. Analysing the stock market returns in these times, we could gauge the ‘high’ inflationary impact. 

Data analysis shows three distinct trends. 

In the 1980s and early 1990s, ‘high’ inflation was accompanied by above-average market returns. For the analysis, any returns above 12% p.a. were considered above-average. 

The five-year average annual inflation in the eighties and early nineties was above 7%, yet the annualised Sensex returns during this period were above 12%.

For instance, as of Mar ‘1985, five-year inflation Averaged 9.9% p.a. (thereby qualifying as a period of ‘high’ inflation), and during that period, annualised Sensex returns (point-to-point) were 28.9%. 

In 1994-95 inflation averaged 9.7%, and Sensex returns were a dazzling 24.3% annualised. It clearly showed a positive correlation trend between high inflation and Sensex returns. 

However, inflation started dropping with the unleashing of economic and financial reforms in the nineties. Since then, there has been a strong inverse relationship between high inflation and Sensex returns. 

From 1995-96, our study found that 86% of the time, ‘high’ inflation had resulted in below-average Sensex returns. Or in other words, in 12 out of 14 years when there was ‘high’ inflation, annualised five-year Sensex returns were below 12% during the corresponding period. 

For instance, as of Mar ’14, when the five-year average inflation hit 10% in Mar ’14, annualised Sensex return was only 9.5%.  Returns remained below “normal” till the average inflation rates were below 7%. 

Thirdly, it has been seen that while high inflation compromises medium-term returns for equity investors, low inflation need not necessarily indicate high returns.

There are other factors at work than just inflation which have a bearing on market returns.

Investor strategy

Given the trend of relatively lesser market returns accompanying ‘high’ inflation, an investor should be prepared for lower returns in the coming years. Moreover, a lot depends on the time the central bank takes to tame inflation. 

Post the 2008 financial meltdown, ‘high’ inflation persisted for many years. Hopefully, it might not continue for that long.

Moreover, long-term investors with an investment horizon of 10 years or more need not get deterred by these trends. Eventually, inflation rates have come down, and stock markets rallied. Since 1985, Sensex has been up 100 times – giving a CAGR of 13.3%. 

So, they are better off staying invested in equities and continuing their SIP investments and asset-allocation strategies. Any tactical moves can otherwise jeopardise their financial goals. 

Takeaway

The article was first published on livemint here on 13 July 2022.