Inflation can be defined as a general increase in price of goods or services over a period of time. Inflation is primarily of two types – cost-push inflation and demand-pull inflation.
Cost-push Inflation can be put down to rising prices on account of an increase in the cost of production (labour, material etc). On the other hand, demand-pull inflation occurs when the demand for goods or services exceed their supply – leading to a rise in prices.
In this post we discuss the possible impact of inflation on stock market prices.
Impact of Inflation on Stock Prices
Moderate levels of inflation brought about by an increase in demand for goods and services, is considered good for the economy. This is because ‘demand’ acts as stimulant providing incentive to the producers of goods and services to produce more by increasing capacity and thereby ‘grow’.
The impact of cost-push inflation on corporate earnings depends upon the ability of a particular company to pass on the hike in input costs onto their customers. Companies competing in price-sensitive industries might find it difficult to raise prices leading to a contraction in margins.
A classic example of this, would be the impact of rising global crude prices on an economy like India which imports most of its crude requirements from outside. An increase in crude oil price in the global markets would lead to an increase in the price of diesel in the Indian markets. This would lead to an increase in transportation costs – incurred in moving both inputs as well as finished goods. An increase in diesel costs would thus exert inflationary pressure on the prices of goods and services.
High level of inflation is undesirable and would prompt central banks to raise interest rates in a bid to control the spiralling prices. For companies with debt, rising interest rates would mean a greater outlay in terms of interest costs – stretching their margins and profitability.
When interest rates remain high for prolonged periods of time, highly leveraged companies find it difficult to service debts – leading to some of their accounts being classified as NPAs by lending institutions.
While moderate inflation caused by a general increase in demand for goods and services might act as a stimulant for the economy, for most companies, however, high levels of inflation would mean contracting margins and a consequent fall in share prices.