Let’s run a simple experiment. You invest Rs 100 every month equally in a mutual fund (MF) or a fixed deposit (FD).
For MFs, you broadly expect about 12 percent annual returns over the long term.
The inflation rate, i.e. the rate at which things become more expensive is 5 percent per year. That means your equity returns give you a “real” return of 12% - 5% = 7% annually.
Hypothetically, the interest rate on your FD is 10 percent, which means your real return from FDs is 10% - 5% = 5 percent.
What if the interest rate drops to 5%? This means you make 0% real returns on your FD. Will you still put money in the FD to generate 0% returns or put most of it in the MF?
While this is an oversimplified version, the conclusion is the same for the broader economy – a decrease in interest rate leads to higher capital flows to the stock market and expected higher rates of return.
An increase in interest rate encourages more savings in banks, reducing the flow of capital to the stock markets. Another angle to study this relationship is to see what interest rate changes do to the businesses behind the stocks you are buying.
For example, there is a manufacturer that uses debt to finance its working capital and expansion. If interest rates go up, it becomes more expensive for it to borrow money.
This means slowing down expansion, hiring, etc. which indirectly means lesser money flows from the business to employees or other businesses. It also means lower profits, which should impact its stock price returns as well.
In conclusion, lower interest rates usually mean high stock returns and vice versa. If only it were that simple! Enter, inflation.
As we discussed above, at lower interest rates, as there is a lot more liquidity in the system, there is a two-fold impact on the stock market. Firstly, equities are more attractive than debt to invest in so stock prices go up.
Secondly, consumers are spending more and therefore, businesses and profits are growing. As a result, GDP growth and stock prices of businesses go up.
However, inflation and interest rates have an inverse relationship. This cycle is self-correcting – all these low interest “good times” keep pushing up inflation.
As there is more money chasing the same goods, it pushes up the price of goods – i.e. inflation starts increasing. To control inflation, the RBI increases interest rates (to incentivize people to save more and reduce the liquidity in the system).
Therefore, RBI is constantly balancing these two in a delicate dance of maintaining growth, keeping sufficient liquidity in the system but keeping interest rates reasonable.
While the impact of interest rates on stock markets is clearer, the relationship between inflation and equity returns is a lot murkier.
Theoretically, equities should be a natural hedge to inflation – since prices of goods are going up, business revenue and profits should grow at the rate of inflation. However, stock price returns do not follow this linear logic.
There are scores of studies that have shown a negative relationship between stock price returns and inflation. However, the issue is a lot more complex. Market reactions are usually an expectation of inflation.
There is a strong negative correlation between expected inflation and anticipated real GDP growth. If markets expect inflation to go up, they expect growth to fall and therefore stocks start falling.
Therefore, the negative relation between stock prices and inflation is really just a proxy for the positive relation between stock returns and future GDP growth.
This implies that the final inflation number is a more lag indicator. What is more important is the drivers of these inflationary expectations.
Hence, the stability of RBI’s monetary policy, messaging on interest rates and inflation targets, shocks to the system on money supply, etc are far more important to track than the actual inflation number that comes out every month.
In conclusion, the RBI is constantly looking to strike a balance between interest rates and inflation. The relationship between these two, the commentary from the RBI, stability of policy and money supply all work together to predict real GDP growth, which in turn drives stock price returns.
(The author is CIO and Co-founder, Upside AI)
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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