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Inflation and the stock markets...

Jun 14, 2007

The US markets tumbled on Tuesday on the back of the news that the benchmark 10-year yield has jumped to a five-year high. Given the kind of relationship bond yields and stock markets share, the latter's reaction was hardly surprising. Buoyed by a rise in virtually every asset class, the world markets are in a sweet spot currently and worries over this leading to a rise in inflation are gaining in intensity with each passing day. Stock markets? Rising rates? Inflation? If this is getting you confused, let us try and simplify this further. Replacement of the old barter system with the new money system is perhaps one of the most significant transitions to have taken place in the history of mankind. While its benefits are manifold, it can sometimes lead to problems like inflation. Imagine a small town where everyone is earning, some more and some less and there are enough goods and services to take care of the needs of the entire population. Now suppose that members from few families go to another town for earning and send back a fixed sum every month. In the case of a low interest rate scenario, the families that receive the fixed sum would rather spend the money on buying certain goods and services, even beyond their needs. Now, since the supply of goods and services is constant or does not increase at a pace so as to satisfy the needs of everyone, it results into their prices going up, what we commonly call as inflation.

The best way to curb this would be to force the families with excess income to save rather than spend and this is achieved through a rise in interest rates. On the other hand, when supply of goods and services far exceed the needs of the people, they are encouraged to consume more through a decrease in interest rates. In the current environment though, prices in virtually every asset class across the globe is going up, pointing to the fact that through money provided by their relatives and well-wishers, people are buying goods and services beyond needs and this is leading to rising inflation. Now one may ask, what is so dreadful about inflation? Generally, the best long-term use money can be put to is to create long-lasting assets like roads, railways, power plants etc. But during times of high inflation, few of these assets get created, resulting into higher wealth destruction than creation. Further, in countries like India, where the divide between the haves and the have nots is even higher, it can even lead to social unrest. No wonder, economies all around the world spend so much time and energy in trying to rein in this devil of inflation.

Higher inflation does not bode too well for the stock markets also. This is because the companies are impacted in two major ways. Higher inflation usually leads to higher interest rates and higher interest rates is not good news for companies, especially those catering to interest rate sensitive sectors like auto and home loans. Here, higher interest rates lead to drop in demand, ultimately affecting the profit making abilities of the companies. Further, it also leads to lower valuations as the opportunity cost rises, thus bringing the present value of all future cash flows down. It is then hardly surprising that the US stock markets reacted in such a harsh manner to the rise in interest rates.

High inflationusually succeed peak valuations and it is during these times that an investor should avoid taking exposure to equities, as its price has been bid up, usually to unsustainable levels. He should in these times, sit back and try to have a clear assessment of the risk reward ratio. Further, one should look out for companies with a stable margin and growth history as normally these are the companies that have withstood the test of inflation and have a strong bargaining power, which enables them to pass on any rise in inflation.

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