Inflation fluctuations influences valuations in the stock market. The risk of higher inflation can trigger a massive sell down in the stock market. Likewise, low levels of inflation has turned out to have a positive impact on valuations in the stock market.
What is Inflation?
Inflation is simply the rate of change in the prices of items in the market. A rise in inflation causes the price of goods and services to increase, consequently reducing the number of items or services that customers can get on each currency unit. Higher inflation consequently has a negative impact on the purchasing power of each currency unit.
Rising inflation causes consumers to purchase fewer goods. In addition, it makes it difficult for companies to purchase inputs. A sudden increase in inflation, many at times, forces companies to pass the costs to consumers.
How Inflation Affects Stock Markets
Central banks strive to ensure that inflation levels remain at acceptable levels. However, in the case of escalating inflation, which makes it difficult for consumers to purchase goods and services, central banks deploy a number of measures.
Rising inflation levels many at times forces central banks to hike interest rates as a way of siphoning excess liquidity from the market. A spike in interest rates to counter higher inflation levels causes investors to their focus to high yielding investments such as bonds and money market funds.
Higher interest rates consequently forces investors to shun stocks and pull their money from equities to more attractive, less risky, and high yielding investments. The result is usually a decline in stock prices.
Likewise, whenever inflation is rising, returns on stock investments tend to decline, consequently pushing the market valuation lower. In this case, stock prices will fall until a point when earnings yield increase to offset the high inflation levels
In times of falling inflation levels, central banks tend to lower interest rates as a way of fuelling liquidity in the market. Lower interest rates force investors to pull their money from high interest rate yielding securities such as bonds and investments in stocks of companies that tend to outperform in times of lower interest rates. An influx of investments into the stock market many at times causes valuation and share prices to edge higher.
Stocks can also beat rising inflation levels. For instance, companies counter rising inflation by raising prices of goods and services to account for the rising costs. By rising prices, companies pass the higher cost to consumers and get to enjoy increased revenues and earnings due to an increase in prices to counter inflation.