Inflation concerns have gripped global markets leading to increased volatility. Inflation concerns remain top of the mind particularly in the US markets, which saw one of their steepest single-day falls since February. Given how aligned Indian markets are to the US and other global markets, if you are wondering what is the fuss about high inflation, here is a primer on what it means for the global and Indian stock markets.
What has happened in the global stock markets?
Earlier this week on Tuesday, the Dow Jones index dropped nearly 1.5%—its highest single-day fall since February—as there were widespread concerns over the possible impact that rising inflation in the US could have on the stock markets. The inflation rate in the US has touched 2.6%, which is way above the Federal Reserve target of 2%. Federal Reserve officials indicated that monetary policy will continue to support the economic recovery in the near term, but if these concerns persist they could change tack.
The US, however, was not alone in experiencing the downswing. UK’s benchmark equity barometer FTSE 100 also lost nearly 2.5% on similar fears while most of the leading equity benchmarks saw significant erosion in investor wealth on the back of similar concerns. The underlying weakness was visible last week in Indian markets as well when Sensex lost over 600 points in two successive trading sessions.
Why is rising inflation bad for the stock markets?
First, let us understand what inflation is. To put it simply, it is the rise in the prices of goods and services. Higher inflation reduces the purchasing power of each unit of currency or rupee in the Indian context.
For companies, high or rising inflation means that input costs would rise. For individuals, it means that they will be able to purchase less or, in other words, consumer spending would go down.
This will have an adverse effect on the company’s income and profits with an overall slowdown in economic growth. Already, companies across a raft of industries are facing an increased strain on supply chains, cost of inputs and labour. These factors are bound to have a negative impact on sentiment, which will be reflected in the stock markets as well.
Can high inflation in the US impact Indian markets?
The most common approach adopted by central bankers globally to counter rising inflation is to raise interest rates. In a low inflation regime, the interest rates would be low and hence investors would look at countries or regions where the interest rates are high to generate higher returns.
In market jargon, it is called ‘carry trade’. It basically means that one borrows in a country that has low interest rate and invests in a country with higher rates and the spread is the profit subject to currency fluctuations. Foreign portfolio investors (FPIs) use this strategy to bring money from their country to invest in Indian stocks.
Now, if the Fed raises rates to counter high inflation—and other central banks follow suit—the spread would shrink and could impact the foreign flows coming to India.
How do companies get affected by high inflation?
Rising inflation leads to higher interest rates. This pushes up the cost of capital for companies. Inflation has an effect on both debt and equity. When inflation rises, bond yields – the rate of interest on bonds – also move up.
Further, the bond prices fall in such a scenario, which is negative for bondholders like banks and mutual funds. Interestingly, the earnings analysis reports by various brokerages have started highlighting the potential impact of higher inflation on the company’s financials going ahead.
Brokerages are expecting a fall in operating margins for many companies in the coming quarters. Commodity prices are on the rise and the companies have two options—either pass on the increased costs to consumers or absorb the hike. Given the current economic and social scenario, it would be difficult for entities to announce price hikes and absorbing the increased costs would only impact the profitability of the companies.
Not to forget that consumer demand has already been hit with India’s retail inflation hovering around Reserve Bank of India’s upper margin of 6% and the ongoing second wave only accentuating the effects further.
Do all companies/sectors react negatively due to rising inflation?
No. Consumer sectors typically experience a bigger hit due to rising inflation. Inflation rate in India is based on the prices of many items including fuel, food and chemicals among others. Companies in sectors like FMCG, paints, chemicals, transportation and automobiles among others are highly dependent on commodities as raw materials and any increase in the commodity prices would increase input costs and hence the margins. On the other hand, sectors like oil & gas and metals are known to perform better when inflation is high.