BackIs high inflation a big concern for equity investors?
It should not deter investors who have a long-term horizon of 10 years or more
PremiumConsumer inflation is at a high across the world. It reached a 40-year high in the US at 8.6% and touched 7% in May in India. Since the Russian invasion of Ukraine, global oil and food prices have risen, stoking inflation in many countries. In its quest to rein in inflation, the US Fed recently raised rates by 75 basis points (bps), while the RBI hiked the repo rate by 90 bps.
High inflation is not new for India and has touched double digits many times in the past. The big question here is: has it impacted the stock market investor returns? 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 affect corporate profitability while making goods less affordable to consumers. And since long-term market index returns move in sync with earnings growth of the constituent companies, poor corporate earnings impact equity return.
Historical relationship
Let’s look at the relationship between high inflation and stock market returns based on several market cycles. Let’s assume, average annual consumer inflation of 7% per annum (p.a.) or more for at least five years is a period of ‘high’ inflation. We can analyse the stock market returns during these times to 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, that is, above 12% p.a.
The five-year average annual inflation in the 1980s and early 1990s was above 7%, yet the annualized Sensex returns for this period were above 12%. For instance, as of March 1985, 5-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 between high inflation and Sensex returns. However, inflation started dropping with the unleashing of economic reforms in the 1990s. Since then, there has been a strong inverse relationship between the two.
From 1995-96 onwards,‘high’ inflation had resulted in below-average Sensex returns 86% of the time. Or, in other words, in 12 out of 14 years when there was ‘high’ inflation, annualised five-year Sensex returns were below 12%. For instance, when the five-year average inflation hit 10% in March 2014, annualised Sensex return was only 9.5%. Returns remained below ‘normal’ till the average inflation rates were below 7%. While high inflation compromises medium-term equity returns, 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, investors with a horizon of 10 years or more need not get deterred by these trends. Eventually, inflation rates have come down, and stock markets have rallied. Since 1985, the Sensex has been up 100 times – giving a CAGR of 13.3%. So, they are better off staying invested in equities for the long haul. Any tactical moves can otherwise jeopardize their financial goals.
Anup Bansal is chief business officer, Scripbox.
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