Posts Tagged ‘financial markets’

Impact of Inflation on Share Prices

Saturday, June 26th, 2010

Impact of Inflation on Share Prices

This is a guest post by Mr.Sacha Singh. Sacha consults on change management, process evaluation and valuation of firms. He also enjoys ghazals and thumris and at times bhajans. You can read his blogs at  http://sachasingh.blogspot.com

 

Here is a piece of simple and intuitive reasoning. Shares represent residual claims on real assets; i.e. claims on assets after creditors’ claims are met; (Equity = Assets – Liabilities). Inflation increases the prices of real assets but does not increase the creditors’ claims. Thus inflation should increase the nominal value of equity. The problem with this simplistic reasoning is that it assumes the value of firm to be the same as the value of the real assets owned by the firm.

It can be argued that if “other things remain the same” (ceteris paribus) and if it is assumed that inflation is uniform i.e. if prices and costs increase uniformly across the board then a firm will be able to pass on all increased costs (raw material, wages etc) to its buyers and its real earnings should remain unaffected. The problem with this argument is that cetera rarely remain at par, i.e. other things do change and inflation is rarely uniform. Some firms manage to pass on increased costs to their customers while some others fail to do so and go bust. Inflation increases earning volatility and hence should reduce value. Thus the value of firms may become lower on onset of inflation even though the prices of its real assets go up in response to the rising prices.

Irving Fischer was perhaps the first economist to investigate into impact of inflation on share prices. He concluded that shares should be a good hedge against inflation. Fisher observed, nominal interest rates consist of two components: a required real return on monies lent and an expected loss in value of money because of inflation. He argued that the required real return is determined by real factors and is unrelated to expected inflation. In other words, the real rate of return required by the investors does not change with expected inflation. During inflation the cash flows from shares go up (because of rise in selling prices). The increased cash flows, discounted with the same old required rate of real returns, would give a higher value and thus share value should go up during inflation, making them a good hedge.

This has not been observed. Periods of inflation, in the USA, have been noted for low returns from stocks. Cohn & Modigliani investigating into failure of equities to act as hedge against inflation concluded that a major part of the apparent undervaluation of shares was due to cognitive errors on the part of the investors. Investors, they felt, fail to realize that in a period of inflation, part of interest expense is not truly an expense but rather a repayment of real principal. The second and more serious error was the capitalization of long-run profits, a real variable, not at a real rate but rather at a rate that varied with nominal interest rates.

Fama & Schwert found evidence that the lowering of share prices (due to inflation) can be explained by two correlations: first between inflation and expected level of economic activities, which are negatively correlated (higher inflation bodes lower economic activities) and second between expected economic activities and share prices, which are positively correlated (higher level of economic activities imply higher stock prices). Taking them together would suggest that inflation should lower the stock prices. Inflation here acts as a proxy for lower economic activities in near future and this line of reasoning is called the proxy effect or the proxy hypothesis. They also distinguished between expected inflation and unexpected inflation.

If we assume that the markets are efficient and inflation will get reflected in risk free rate then onset of inflation would increase investors’ required rate of return from equities and even if a firm’s revenues keep up with inflation, its value will suffer because of higher discount rate.

There are other effects of inflation. If inflation rate moves up, in the first year post higher inflation, the accounting statements may be under-reporting the COGS (and thus, over-reporting profits) if the firm follows FIFO accounting; with LIFO accounting this impact will be insignificant.

Inflation increases the value of fixed assets, but depreciation continues on historical values. Thus, an older firm would charge considerably less depreciation (and pay, ceteris paribus, higher taxes) than a newer firm. The accounting profit of older firm may be high but the cash flow of the newer firm would be stronger.

In India reliable data of index PE is conveniently available only from 1999 onwards. I did a regression of quarterly PEs of Nifty and inflation numbers (derived from CPI – industrial workers). I could find no correlation. But Nifty PE regressed with inflation as recorded after two quarters gave an interesting straight line (with R2 at a little over 40%)! If PE goes up (down) today, inflation would be up (down) after two quarters!!

I do not know what to make of it. A somewhat bold reasoning could go like this. PE’s are going up because of increasing money supply. And broad measure of money supply (M3) generally co-integrates with inflation). FII funds that come to the stock market increase PE today and affect the inflation after some time. I call it bold because it is being hypothesized without examining the data (of FII inflows) and the transmission mechanism.