How does inflation affect the stock market?

Q: The stock market has been falling lately due to fears of rising inflation. My broker told me that there is risk of a further selldown in share prices because of a higher inflation outlook next year. I have invested some of my savings in stocks and I am thinking if I should get out now or buy more. Can you advise me? —Cameline Canlas by email

Inflation has been slowly rising since the start of the year. With so much money in circulation against the backdrop of a growing economy, there is no doubt that the risk of strong inflationary pressure in the next few months is possible. This is the reason why market traders and investors are taking this as an excuse to lighten their stock market portfolios.

When there is threat of escalating inflation, the central bank tries to control this by raising interest rates. By increasing interest rate, they hope to attract investors to park their cash in fixed income instruments, thereby siphoning off excess liquidity from the system. Theoretically, when there is less liquidity, there is less speculative demand for goods in the economy, hence slowing down the increase in general prices.

The prospect of higher interest rates is bearish for the stock market because it encourages investors to lock in their cash from equities to more attractive, less risky securities, like money market funds. The lower the funds flow into the market, the lower the demand for stocks, hence lower share prices.

The other way to look at it is by valuation. The expectation of higher inflation is what is driving the market crazy at the moment. When there is uncertainty, the risk premium tends to increase, which leads to higher expected returns from the stock market.

Let’s say you put risk premium of 1 percent on top of the current inflation rate of 4.9 percent, so your minimum expected return must be 5.9 percent. For you to make this kind of return from stocks, you need to buy the market at its equivalent price-earnings (P/E) ratio or lower.

How do you compute this? Assume that the expected return of 5.9 percent is the earnings yield, which is represented as E/P. To get the equivalent P/E, you simply divide the number one by 5.9 percent to derive 17x ratio. If you compare this valuation to current market P/E of 21x, you should expect the market to correct further before you start buying again.

Imagine if inflation continues to increase, the minimum return on stock investment will also be higher which will push market valuation lower. Share prices will fall until the estimated earnings yield increase to a point enough to offset the expected inflation.

The expectation of rising inflation, albeit benign, can adversely affect the stock market in the short-term. However, this should not discourage from participating in the market. In fact, this is the best time to invest at good price if the market falls further.

Investing in stocks can be a good hedge against inflation over the long term. Stocks are one of the few assets that you can rely on when it comes to beating inflation. The other asset that you can consider is real estate which tracks inflation through value appreciation. However, this is not as liquid as stocks. You may find it difficult to sell at the price you want when you need money.

Rising inflation can cause the most damage in fixed income securities. If you have put your money in bonds and long-term commercial papers, you are most likely going to lose in real terms if the interest rate per annum that you agreed to receive is less than the current inflation of 4.9 percent. If inflation goes up further, the higher the increase, the larger your losses will be in real terms.

Stocks can beat inflation over time because companies can raise prices to account for rising costs brought about by inflation. For example, when cost of sales and wages increases due to inflation, companies can simply pass on the higher cost to consumers by raising prices over time. When companies increase their prices, their revenues and earnings also increase. The higher the earnings, the higher the valuation, which leads to higher share prices.

Let’s look at historical statistics for the last five years. Since September 2009, the stock market index has grown from 2,802 to 7,200 today by an average growth rate of 21 percent. This growth is way beyond the annual inflation rate which averaged only less than 6 percent throughout the whole period. The excess return of 15 percent is the value that is created by investing your money in the stock market.

During the same period observed, you will see that almost all profitable companies listed in the market have demonstrated high compounded returns per year in five years. Among the notable stocks are Universal Robina, 74 percent; DMCI, 56 percent; Aboitiz Equty Ventures, 50 percent; ICTSI, 39 percent; Jollibee, 31 percent; Metrobank, 25 percent; Megaworld, 25 percent and Ayala Land, 24 percent.

Imagine if you have invested P10,000 worth of URC shares in 2009, this investment would have now grown to P159,500, an increase of 16 times! Of course, this is just one of the extreme cases that you can possibly benefit by keeping your money in stocks for long-term.

Note that not all listed stocks have this kind of returns. Some just have returns of above 10 percent by beating average inflation rate such as PLDT, Meralco, BPI, SM Prime and Filinvest Land, to name a few. Some stocks have returns below average inflation rate and some have even negative returns since their IPO listing.

Take advantage of inflation fears. Never mind if the market falls. Buy blue chips at attractive prices and hedge your savings against inflation for the long term.

Henry Ong is a Registered Financial Planner of RFP Philippines. To learn more about financial planning, attend our FREE personal finance talk on Sept. 18, 7 p.m. at PSE Ortigas. To reserve, e-mail at [email protected] or text <name><email><RFPinfo> at 0917-3464126.