In order to under stand how inflation affects stock market, first we need to understand how inflation can affect a business in general. In order to run a business, people generally borrow money from Banks for their daily operations, to purchase raw material etc. When inflation goes up, cost of raw material also goes up, so the margin goes down drastically.
Say you are selling a Tupperware lunch box product for Rs.500, in order to manufacture this product you need to purchase raw materials like Vinyl, polyethylene and Polypropylene and it would cost you Rs.300. Your profit margin is Rs.200 for every product you sell.
But due to inflation if the cost of material increases and instead of Rs.300, if your cost goes upto Rs.400, then your profit margin is only Rs.100 when you sell if for Rs.500. This is going to affect the profitability of your company.
And as I mentioned earlier, many company borrow money from banks in order to ramp up their productions. Consider you borrowed 10 Crores from Bank with x% interest rate, tomorrow if RBI increases the interest rate due to inflation, then your loan interest rate will also go up. Then your liability increases as you have to pay more EMI now compared to earlier months. This is obviously going to affect quarterly performance of the company, consider if it is a listed entity then the moment company announces a bad quarterly results then its stock price is going to crash at least for a temporary period.
So a rise in inflation sets a chain reaction that is not only going to affect a normal working professional like you and me who purchased a home loan, its going to affect the entire economy which in turn affects the stock market. After all, stock market movement is solely based on a country’s economy. But the important point to keep in mind is, historically there has been many instances where inflation has increased and stock market also moved up. So we cannot be very sure that rise in inflation will always end up with a stock market crash.
Many factors contribute to stock market performance, and inflation is just one of them. The current stockmarket correction is mainly due to the pulling out of money from risky asset classes by large institutions who use to borrow money at almost zero interest rate earlier, since FED continued to print money for a long period and kept interest rate at an extremely lower levels. Now with FED and other central banks around the world started increasing the interest rate, cost of borrowing increased for these institutions, so they ended up selling their positions in equity market across the globe.
But the good news is inflation doesn’t usually stay at a higher level for prolonged period of time, with such tightening measures from central banks, it should go down in coming months. Also stock market also corrected significantly in recent past, many over valued stocks have gone down drastically. Definitely these are good time to accumulate quality stocks for long term investments.