What is stock market and stock exchange?
“Stock market is a place where people who want to invest their money in stocks come together and perform the buying and selling of such stocks over the stock market.”
Trading in stock markets refers to the transfer of securities or stocks between sellers and buyers on an agreed price. The various instruments which can be traded in the stock market are equities, bonds, etc. and the investors could be an individual, large investment companies, banks, pension funds, insurance companies, etc.
Trading of these stocks happens in stock exchange with the help of brokers who act as intermediaries between buyers and sellers. NSE and BSE are India’s famous stock exchanges.
What is Inflation?
Inflation refers to a rise in the prices of goods and services in the economy over a period. It indicates the loss of purchasing power of people in the economy due to expanded price, unchanged earnings, a decline in corporate profits and the standard of living, etc.
There are mainly two causes of Inflation:
- Demand-Pull Inflation:
In Demand-Pull Inflation, the demand for the goods and services available in the economy rises above their supply. Due to such condition, the goods become scarce and the buyers are willing to pay much higher prices for the same commodities, thus pushing up the prices.
- Cost-Push Inflation:
In Cost-Push Inflation, the cost of production of some goods in the economy increase by increase in their cost of raw materials, wages, etc., and this addition in cost of factors of production leads to decrease in supply. However, the demand remains the same and therefore results in an overall rise in price levels.
For example; India is recently facing Inflation in its retail sector, reaching an eight-month high of 3.18%
Effect of Inflation on the stock market
The effect of Inflation on the stock market can be positive or negative depending upon the country’s monetary policy and the ability of investors to hedge.
- Impact on purchasing power of investors:
In the case of increase in the Inflation rate in an economy, the present value of the money that we will receive in future reduces, i.e., with the reduction in PV, we are able to purchase less from the same amount as compared to earlier.
For example: At a current rate of Inflation of 5%, our receivable of Rs1000 one year later will be valued at Rs 950 today. But if the rate of Inflation increases to 10% the receivable will only be valued at Rs 900 today.
Such a reduction in purchasing power usually has a negative impact on the consumer-driven stocks such as FMCG and consumer durables. It also forces the companies to cut down their prices which in turn leads to lower profits.
- Impact on interest rates and valuations:
As a result of an increase in the Inflation rate, the interest rates go up, which results in decrease in the value of bonds, equities and debt.
This fall in the prices of the bonds leads to capital losses for bondholders like banks and mutual funds. Therefore, rising interest rates usually are negative for banks.
When Inflation goes up and the interest rates go up, the cost of capital also goes up. Therefore, the future cash flows of the company will be valued lower. We know that the valuation of equities is done by discounting future cash flows so when the rate of discounting goes up, equity valuations go down.
- Impact on stocks
Unexpected Inflation contains new information about future prices and creates higher volatility of stock movements which in turn correlates with higher Inflation rates.
Stocks are usually categorized into value and growth. Value stocks have strong cash flows whereas growth stocks have little or no cash flow. Growth stocks are negatively impacted at the time of the increase in interest rates, i.e., time of high Inflation. While the relationship between value stocks and Inflation is positive.
The effect of Inflation on stocks that pay dividends or income-generating stocks is negative. Since rising Inflation makes them less attractive because the dividends are not enough to cope up with the Inflation levels and also the taxation levels stay constant which causes a double-negative effect.
- Impact on Sensex and Nifty
With the rising Inflation people have less to spend and have lesser savings because of rising prices. The investments in the stock market also go downhill because the investors have fewer cash holdings. Therefore, rising Inflation creates an adverse on the Nifty and Sensex market and vis-à-vis.
However, at times rise in the Inflation levels is also considered good as it helps in stimulating growth in countries.
How can Inflation be controlled?
In situations when the Inflation rate in the economy increases to a level where it cannot be controlled by market forces, the government steps in and implement policies to curb the Inflation rates.
Thus, in cases where the prices are too high the government forces a contractionary monetary policy wherein it tries to decrease the money supply in the economy in order to increase the cost of borrowing which in turn leads to decrease in GDP and curbs Inflation.
The implementation of contractionary monetary policy means lesser credits available in the market, increase in interest rates to promote saving and increase in reserve requirements of the banks by the RBI in order to restrict the loans given to the public and reduce liquidity in the market.