Is high inflation a big concern for equity investors?

High inflation is not new to India and has touched double digits several times in the past. The big question here is, has this affected the returns of stock market investors? High inflation affects corporate earnings in several ways. For example, it reduces consumer spending power. Second, the high interest rates that are usually combined with persistently high inflation affect corporate profitability while making goods less affordable for consumers. And since long-term market index returns tend to sync with the earnings growth of constituent companies, poor corporate earnings impact equity returns.

historical link

Let’s look at the relationship between high inflation and stock market returns based on multiple market cycles. Let’s assume, an average annual consumer inflation of 7% per annum (per annum) or more for at least five years is a period of ‘high’ inflation. We can analyze the stock market returns during these times to assess the ‘high’ inflationary effect. Data analysis shows three distinct trends: in the 1980s and early 1990s, ‘high’ inflation was accompanied by average market returns, that is, more than 12% per annum.

The five-year average annual inflation in the 1980s and early 1990s was above 7%, yet the annual Sensex return for the period was above 12%. For example, as of March 1985, 5-year inflation averaged 9.9% per annum (thereby qualifying as a period of ‘high’ inflation), and during that period, annual Sensex returns (point-to-point) was 28.9%. Inflation averaged 9.7% in 1994-95, and the Sensex yield was 24.3% annually. It clearly showed a positive correlation between higher inflation and Sensex returns. However, inflation began to decline with the introduction of economic reforms in the 1990s. Since then there has been a strong contrast between the two.

Since 1995-96, 86 per cent of the Sensex returns have been below average as a result of ‘high’ inflation. Or, in other words, in 12 of the 14 years when there was ‘high’ inflation, the annual five-year Sensex return was less than 12%. For example, when the five-year average inflation hit 10% in March 2014, the Sensex’s annualized return was only 9.5%. Returns remained below ‘normal’ until the average inflation rate was below 7%. While high inflation compromises medium-term equity returns, low inflation does not necessarily imply higher returns. Factors other than inflation alone are at work that have an impact on market returns.

investor strategy

Given the trend of relatively low market returns coupled with ‘high’ inflation, an investor should be prepared for lower returns in the coming years. Furthermore, much depends on how long it takes the central bank to control inflation. After the 2008 financial meltdown, ‘high’ inflation persisted for several years. Hopefully, this may not continue for long. Furthermore, investors with a horizon of 10 years or more need not deviate from these trends. Eventually, the rate of inflation decreased, and the stock markets rose. Since 1985, the Sensex has risen 100 times – giving a CAGR of 13.3%. Hence, they are better than investing in equities for the long term. Any strategic move may otherwise jeopardize their financial goals.

Anoop Bansal is the Chief Business Officer of Scripbox.

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