How Economics Affect Equity Markets- Part 1
By: Shyam Agarwal
Tags: Liquidity, Inflation, Market, Equity, Economics

This is blogpost is inspired by one of Marcellus Investments’ previous work on Inflation.

The fondest economic obsession for Indians is the GDP figure. Following next very closely is Inflation. Inflation has been the recent talk of the financial town, with inflation readings inching higher and sometimes crossing the upper target band of the Reserve Bank of India (RBI) since the latter half of 2020. For the uninitiated, the RBI inflation target band is 4(+/-2)%.

From Jan’12 to Jul’21

Before sketching the effect of inflation (high/moderate/low) on equity markets, we need to understand why inflation is so much being talked about. Ever since the onset of the Covid-19 pandemic, central banks, across the globe have flushed the system with excess liquidity. They want to support growth and liquidity will act as a lubricant for the wheels of the economy. This excess liquidity is finding its way to the equity markets.

But why only equity markets? The reason is the extremely low interest rate cycle. The excess liquidity in the system is achieved by lowering down interest rates so that more entities go ahead to borrow money from financial institutions and in turn spend on the economy, paving way for growth. Therefore, with elevated inflation levels and no competitive alternative asset class, equities becomes a no-brainer.

Now coming to the inflation effect on equities. Perenially, inflation has been viewed as being negatively correlated with equities. Should inflation go up, stock markets would correct. The basic narrative is that once inflation is high, the central bank will raise interest rates and that would have a negative bearing on the equity market, by the same logic as mentioned earlier. This might not be true, though.

Using the past 9 years and 7 months worth of historical data (115 months) from January’12 to July’21, I conducted a study of Nifty50 returns during this period. The data set is divided into High/Moderate/Low Inflation months. Any reading equal to or above 6% is considered high, between 4–6% is considered moderate, and below 4% is considered low. The bifurcation is attached below.

The Nifty50 Returns represent the median monthly returns

The bottomline of the study was that the Nifty50 index actually outperformed (on a cumulative basis) during the high inflation period as compared to the moderate and low inflation periods. Since the returns are median in nature, it neutralizes some portion of the sample space bias.

What’s the rationale behind this? Essentially what happens is that during high inflation months, companies across the board face input cost acceleration. This trickles down to their margins and in turn the burden is passed on to the end consumer. However, top-quality companies tend to operate otherwise. They typically have a strong distributor network and a healthy inventory churn which enables them to cushion the input cost inflation and hence keep the margins intact. This usually reflects on their stock prices, that is corroborated by the underlying analysis.

Therefore, top notch businesses manage to break the clutter during difficult business conditions and extend their lead significantly. Another thing to bear in mind, is the importance of equity as an asset class. Equities are the best way to beat inflation and generate plausible returns over a long period of time, by undertaking moderate amount of risk. Hence, what seems to be the case is always not the case.