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Direction, not the level of inflation that matters

Direction, not the level of inflation that matters
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First Published: Fri, Mar 11 2011. 03 50 PM IST

Updated: Fri, Mar 11 2011. 03 50 PM IST
New Delhi: Finance minister Pranab Mukherjee said in parliament on Friday that inflation is the most worrying problem. The folks at Espirito Santo say inflation might not be as big a devil as it is being made out to be. At least from the point of view of equity returns.
Espirito’s Nick Paulson-Ellis argues that it’s the direction not the level of inflation that matters for stocks. According to their analysis, returns of Indian stock markets are not that strongly correlated with the level of inflation.
Espirito notes:
There is a negative correlation in India between the level of inflation and real equity returns, but not a strong one (-0.33). Somewhat counter intuitively, we found that there was no significant impact of inflation on Sensex companies PAT margins.
India Inc is in fact more susceptible to low than high inflation. A ten-year analysis of PAT expansion for the Sensex 25 (Sensex 30 excluding Banks, Oil and Gas) shows that companies suffer high margin compression in a low inflationary environment. PAT of Sensex 25 actually grew 1% more than the long-term average of 25% in high inflationary quarters.
That is a surprising conclusion. But then it might be due to the fact that the Sensex companies are among the biggest in the country. So they have significant pricing power and are able to pass on the costs. Also, some companies might have tied up supplies through longer contracts and Espirito doesn’t seem to have examined the lag effects of inflation.
Be that as it may, the bank notes that returns from Indian stocks are highest when inflation is coming down.
Nick Paulson-Ellis writes:
The correlation between Sensex real returns and direction of inflation is better than simply the level of inflation. The direction of inflation is defined as the sequential (MoM) change in WPI inflation. The annual nominal return on Sensex is 39% in the months of decreasing inflation as compared to 16% when inflation is on an uptrend.
For now, inflation seems to be trending down. But then global factors such as crude prices, Chinese trade deficits and the Japanese earthquake weigh on investor sentiments.
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First Published: Fri, Mar 11 2011. 03 50 PM IST
More Topics: Markets Update | Inflation | Markets | Index | Prices |