Why inflation is bad for markets?

We have discussed what stocks do well in high inflation in our previous article, but in this one we discuss why share markets do not like inflation.

  • Increased cost of raw materials for companies may cause expenses to increase. Companies will pass these increased costs to consumers making the product more expensive. The increase of price may mean less units are sold as demand is decreased.

 

  • If there is a general level of price increases of everything and there is no wage growth, households will need to stretch their household budgets further. Essential services would be prioritized and demand for non-discretionary services would decrease.

 

  • Higher interest rates may be implemented to control inflation if it is too high. Company interest obligations will increase if rates are hiked increasing expenses and affecting profits. Consumers are also affected by interest rate rises so if their mortgage obligations are increased, they will have less money to spend on products and services which reduces profits for companies

 

  • When an analyst evaluates a stock, they use the discounted cash flow method to assess whether the stock is an attractive buy. The analyst uses future free cash flow projections and discounts them to obtain a present value. To achieve this present value, they use 10-year bond yield to arrive to a present date value for that company. In times of high inflation, higher bond yields will follow, these discounted cash flows will rise and will make stock valuation look more expensive.

 

  • High inflation may then lead to a stagnation or lowering of company profits which can mean depressed share prices and lower dividends.

 

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Lauren Hua is a private client adviser at Fairmont Equities.

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