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B. Venkatesh

THAT Inflation affects our consumption pattern is known. But what is the relation between inflation and the stock market?

Typically, higher inflation leads to lower equity values. Why? Take Reliance Industries. Assume that you want to hold this stock for a long time. Essentially, you are buying the stock to receive dividends in the future.

Suppose the present value of these cash flows is Rs 500. So, you think that buying the stock at Rs 475 is a good deal. Now, suppose price levels increase. The market assumes that the interest rate will also rise. An increase in interest rate will make the present value of the future cash flows less valuable. Why?

The present value is the reverse of compounding. When interest rate rises, you get more money in the future for the same amount invested now. It, therefore, logically means that for some amount to be received in the future, its value should be lower today.

Further, when the interest rate rises, bonds become attractive. Suppose the average bond and stock return is 7 per cent and 12 per cent respectively. This difference of 5 per cent is termed risk premium in financial economics.

The risk premium is the compensation that equity investors demand for bearing higher risk. After all, you can lose a lot of money buying a stock. That will not happen with bonds, unless the company refuses to repay the principal!

Now, higher in inflation raises uncertainty in the economy. The increased uncertainty prompts investors to demand higher risk premium, which means higher returns on equity. Assuming that the future cash flows on these stocks do not change, a higher return is possible only if the stock prices decline now.

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