Keeping in mind all the well known definitions of inflation, it can be simply said that inflation is a state in an economy of a country, when there is a price rise,in goods and services and the population needs to shell out more than just an extra penny to survive in the forth coming.
For Example: I remember, my grandfather once said that in one rupee was just enough for his monthly basic purchases. But, in GEN-X, it requires a minimum of a ten times a grand for entire month. This rising of prices, year after year is called effect of Inflation.
Now the question is does inflation affects the stock markets? If yes, is it good or bad? There have been many debates and views to these above mentioned questions. Some said, it is good to invest in equities as they help to hedge against inflation. (Hedge: An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security.) The cash if left alone will obviously not give us returns. Saving in banks will earn mere returns. Trading via stocks and investments in mutual funds are beneficial, but, that is possible only when, rate of inflation is less than the rate of return. Trading and making investments calls for higher risk; at the same time intelligent investments can help earn higher returns.
Lets’ consider another example:
• Rate of Return is nothing but how much we earn on making an investment. That is [(Payback-Original Investment)/ Investment]*100.
• Rate of inflation in India, for the month of November 2010 stood at 9.7%. So, in simple terms if we buy anything worth Rs. 100 then it would cost Rs. (100+9.7)= Rs. 109.7.
Prices of stocks are determined by the net earnings of a company. It depends on how much profit, the company is likely to make in the long run or the near future. If it is reckoned that a company is likely to do well in the years to come, the stock prices of the company will escalate. On the other hand, if it is observed from trends that the company may not do well in the long run, the stock prices will not be high. In other words, the price of stocks are directly proportional to the performance of the company. In the event when inflation increases, the company earnings (worth) will also subside. This will adversely affect the stock prices and eventually the returns.
Hence, if the payback is more than the rate of inflation, its only then the investment made in stock market can help in hedging inflation. In case of India, the inflationary pressures have had adverse effects on stock markets. Let us see the Stock Market (BSE) Vs Inflation (CPI) charts.
(Source: tradingeconomics.com, India Ministry of Labour)
Viewing this chart, it can be clearly seen that in situations of increasing inflation the stock markets have taken a dip.
Sify on 10th January, 2011 reported, “The market ended on a dismal note today, extending its losses to a fifth successive session, as concerns about inflation and fears of an interest rate hike and the likely slowdown in economic growth triggered another strong round of selling across the board. Weak global markets and reports that FIIs were selling heavily over the past few sessions too hurt sentiment to a notable extent.”
Reasons of FIIs selling can be attributed to inflationary pressures leading to devaluation of currency. In case of inflation, the value of Rupees as compared to international currency will lower. Hence, the foreign may see more gains in selling their stocks. This also affects the foreign trade.
Inflation or recession will also have internal differences in how the currency of a country is assessed. Inflation in particular has the ability to devalue the currency. Because when a country enters a period where inflation is rampant, the attractions of the currency will decline, which is perceived as less stable. Since inflation reduces the purchasing power within a country.
Inflationary pressures leads to rise of cost of production in various sectors, may it be goods or services. Cost of production includes the cost of raw materials and cost of manpower. Resulting from the higher costs, the profit margins would decline as well as there would be increase in purchasing power of other economies. Therefore more units of goods and services can be purchased, though at marginal increase in cost.
Considering the textile industries as an example, the variation in exchange rate that adversely affects the textile manufacturer’s profits may be due to seeming unrelated factors such as increase or decrease in capital inflows in the form or Foreign Direct Investment or Foreign Portfolio Investments or RBI intervention as the case may be. The woes of the exporters are not limited to the rise of Rupee against the USD. Domestic inflation and rising raw material prices exert further strain on already dwindling profits. For instance, there is a rise in cotton prices globally which makes the procurement of good quality raw material, expensive. (Source: http://www.fibre2fashion.com/industry-article)
This example very correctly brings out the difficulties faced in international trade in situations of inflation. Low profitability due to rise in cost of production, high interest rates from banks in case of loans and borrowings, units exported are sold at lower cost due to devaluation of Rupees.
For Example: I remember, my grandfather once said that in one rupee was just enough for his monthly basic purchases. But, in GEN-X, it requires a minimum of a ten times a grand for entire month. This rising of prices, year after year is called effect of Inflation.
Now the question is does inflation affects the stock markets? If yes, is it good or bad? There have been many debates and views to these above mentioned questions. Some said, it is good to invest in equities as they help to hedge against inflation. (Hedge: An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security.) The cash if left alone will obviously not give us returns. Saving in banks will earn mere returns. Trading via stocks and investments in mutual funds are beneficial, but, that is possible only when, rate of inflation is less than the rate of return. Trading and making investments calls for higher risk; at the same time intelligent investments can help earn higher returns.
Lets’ consider another example:
• Rate of Return is nothing but how much we earn on making an investment. That is [(Payback-Original Investment)/ Investment]*100.
• Rate of inflation in India, for the month of November 2010 stood at 9.7%. So, in simple terms if we buy anything worth Rs. 100 then it would cost Rs. (100+9.7)= Rs. 109.7.
Prices of stocks are determined by the net earnings of a company. It depends on how much profit, the company is likely to make in the long run or the near future. If it is reckoned that a company is likely to do well in the years to come, the stock prices of the company will escalate. On the other hand, if it is observed from trends that the company may not do well in the long run, the stock prices will not be high. In other words, the price of stocks are directly proportional to the performance of the company. In the event when inflation increases, the company earnings (worth) will also subside. This will adversely affect the stock prices and eventually the returns.
Hence, if the payback is more than the rate of inflation, its only then the investment made in stock market can help in hedging inflation. In case of India, the inflationary pressures have had adverse effects on stock markets. Let us see the Stock Market (BSE) Vs Inflation (CPI) charts.
(Source: tradingeconomics.com, India Ministry of Labour)
Viewing this chart, it can be clearly seen that in situations of increasing inflation the stock markets have taken a dip.
Sify on 10th January, 2011 reported, “The market ended on a dismal note today, extending its losses to a fifth successive session, as concerns about inflation and fears of an interest rate hike and the likely slowdown in economic growth triggered another strong round of selling across the board. Weak global markets and reports that FIIs were selling heavily over the past few sessions too hurt sentiment to a notable extent.”
Reasons of FIIs selling can be attributed to inflationary pressures leading to devaluation of currency. In case of inflation, the value of Rupees as compared to international currency will lower. Hence, the foreign may see more gains in selling their stocks. This also affects the foreign trade.
Inflation or recession will also have internal differences in how the currency of a country is assessed. Inflation in particular has the ability to devalue the currency. Because when a country enters a period where inflation is rampant, the attractions of the currency will decline, which is perceived as less stable. Since inflation reduces the purchasing power within a country.
Inflationary pressures leads to rise of cost of production in various sectors, may it be goods or services. Cost of production includes the cost of raw materials and cost of manpower. Resulting from the higher costs, the profit margins would decline as well as there would be increase in purchasing power of other economies. Therefore more units of goods and services can be purchased, though at marginal increase in cost.
Considering the textile industries as an example, the variation in exchange rate that adversely affects the textile manufacturer’s profits may be due to seeming unrelated factors such as increase or decrease in capital inflows in the form or Foreign Direct Investment or Foreign Portfolio Investments or RBI intervention as the case may be. The woes of the exporters are not limited to the rise of Rupee against the USD. Domestic inflation and rising raw material prices exert further strain on already dwindling profits. For instance, there is a rise in cotton prices globally which makes the procurement of good quality raw material, expensive. (Source: http://www.fibre2fashion.com/industry-article)
This example very correctly brings out the difficulties faced in international trade in situations of inflation. Low profitability due to rise in cost of production, high interest rates from banks in case of loans and borrowings, units exported are sold at lower cost due to devaluation of Rupees.
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