# Relationship between inflation and stock market returns

Jan 21, So from this chart you can see that there doesn't appear to be a correlation between high inflation and high stock market returns. If anything. Sep 17, The prospect of higher interest rates is bearish for the stock market Imagine if inflation continues to increase, the minimum return on stock. This paper investigates the relation between common stock returns and inflation in twenty-six countries for the postwar period. Our results do not support the.

The leverage effect for Bahrain is negative indicated the existence of the leverage effect in stock market return during the The impact is asymmetric. The leverage effect for Egypt is positive indicated the non existence of the leverage effect in stock market return during the Results were similar for Jordan. For Oman and Saudia Arabia there was no news effect of inflation on stock market data. The coefficients of unexpected inflation were negative and highly significant.

Only Oman and Egypt shown insignificant results where unexpected inflation shows no effect on stock market return data in the sample period. The asymmetric news effect was absent. Kim and Ravi were explained the cross-sectional variation in the relation between international security returns and expected inflation based on their sensitivities to world stock and bond factors. The paper shows inflation sensitivities of returns on country indexes and international mutual funds on their sensitivities to world stock and bond indexes.

The result from OLS regression coefficient for return sensitivity of stock to the stock market factor was negative and significant at the five percent level. The coefficient for return sensitivity to the bond market factor was positive and significant at the one percent level.

Thus, the results support the hypothesis that the inflation sensitivity of a security was negatively related to its stock market return sensitivity and positively related to its bond return sensitivity. Concluded that the inflation sensitivity of a security is positively negatively related to its sensitivity to the world bond index world stock index. Al-Khazali investigated the generalized Fisher hypothesis for nine equity markets in the Asian countries: It states that the real rates of return on common stocks and the expected inflation rate were independent and that nominal stock returns vary in a one-to-one correspondence with the expected inflation rate.

The results of the VAR model indicate the nominal stock returns seem Granger-causally a priori in the sense that most of the forecast error variances is accounted for by their own innovations in the three-variable system; inflation does not appear to explain variation in stock returns; stock returns do not explain variation in expected inflation. The stochastic process of the nominal stock returns could not be affected by expected inflation.

The study fails to find either a consistent negative response of stock returns to shocks in inflation or a consistent negative response of inflation to shocks in stock returns in all countries. The generalized Fisher hypothesis was rejected in all countries. Another investigation from Al-Khazali explained the negative relationship between real stock returns and expected inflation in the Jordanian economy.

The study examines whether the proxy-effect hypothesis can adequately explain the negative relationship the two variables. The study contributed in validates the Fisherian Hypothesis for stock market returns of the several developed economies. On the other hand, contributed in effectively to hedge against inflation in Jordanian countries.

The OLS result show that a negative relationship between expected inflation and expected real stock returns. Meanwhile, the study was not support the proxy-effect hypothesis for Jordanian economy. Diaz and Jareno investigate the short run response of daily stock prices in the Spanish market to the announcements of inflation news on a sectorial level.

The aim was to study the relationship between unanticipated inflation news and stock returns, focusing our analysis on the sector of activity. The methodology based on time-series event-study methodology included a large number of recent papers used these approach to analyze the repercussion of some macroeconomic announcements on returns of different market indexes, interest rates or stocks. The result shown coefficients of all sectors in the preannouncement period are not statistically significant.

- Is There a Correlation Between Inflation and the Stock Market

No evidence of a significant relationship between abnormal returns and total inflation during this period is found. The proximity to the announcement originates uncertainty in the market but these abnormal returns were independent of the final amount of the total inflation rate. Moreover the coefficients of all sectors are always positive and higher than coefficients corresponding to the pre-announcement period. In contrast to literature and the study was observe a significant positive relationship between stock returns and inflation changes for the Spanish market as a whole and for several sectors.

This was the case of the companies from sectors that show an insignificant relationship between abnormal returns and inflation rate, and also from sectors in which this relationship is significant and positive.

Lastly, relationship between inflation rate and abnormal returns was negative in the post-announcement period, but the coefficient is statistically insignificant. There was no evidence of a possible adjustment of prices subsequent to an overreaction on the announcement day. Adrangi, Chatrath, and Sanvicente investigates the negative relationship between stock returns and inflation rates in markets of industrialized economies for Brazil.

It was important because given high inflation rates among these economies, there a rising interest by investors in emerging markets. The negative relationship between the real stock returns and inflation rate for Brazil persists even after the negative relationship between inflation and real activity is purged. Therefore, real stock returns may be adversely affected by inflation because inflationary pressures may threaten future corporate profits; and nominal discount rates rise under inflationary pressures, reducing current value of future profits and lastly on stock returns.

The results support the interesting notion that the proxy effect in the long-run rather than short run. Schwert analyzed the reaction of stock prices to the new information about inflation.

He stated that the important reason to expect a relationship between stock returns and the unexpected inflation was that unexpected inflation contained new information about future levels of expected inflation. Despite of debtor or creditor hypothesis, it was difficult to predict the distributive effects of unexpected inflation on stock returns. The unexpected inflation have variety of effects on the value of the firm, and unexpected increase in expected inflation could cause government policy-makers to react by changing monetary of fiscal policy in order to counteract higher inflation.

He found that the stock market seem not react to unexpected inflation during the period of Consumer Price index was sampled on several weeks before the announcement date. The study used simple regression analysis. The result was not one of the two selected countries offers a perfect hedge against inflation.

The South African experience shows that the companies listed in the mining sector are negatively correlated against inflation. The selected companies in financial services, information technology, and food and beverage sectors show slightly positive correlation between stock price changes and inflation.

All the selected companies of Namibia except Alex Forbes show a strong positive correlation between stock price changes and inflation. Abu explored the varying volatility dynamic of inflation rates in Malaysia for the period from August to December Exponential generalized autoregressive conditional heteroscedasticity EGARCH models are used to capture the stochastic variation and asymmetries in the financial instruments.

Another result shows that there was no contemporaneous relationship between inflation uncertainty and inflation level. There was sufficient empirical evidence that higher inflation rate level will results in higher inflation uncertainty. Saryal studied the impact of inflation on conditional stock market volatility in Turkey and Canada. He examined the two questions. First, how does inflation stock market volatility estimated by using nominal stock return series.

Second, does the relation differ between countries with different rates of inflation. The Canada and Turkey data were selected for comparison on the basis of their inflation level. The reason of selected countries because Turkey was an emerging market country with a high inflation rate and Canada a developed country with a low inflation rate.

The results suggests that the higher the rate of inflation, the higher the nominal stock returns consistent with the simple Fisher effect. The result showed the rate of inflation was one of the underlying determinants of conditional stock market volatility particularly in a highly inflated country like Turkey. The variability in the inflation rate had a stronger impact in forecasting stock market volatility in Turkey than in Canada.

Choudhry investigated the relationship between stock returns and inflation in four high inflation Latin and Central American countries: Argentina, Chile, Mexico and Venezuela during s and s. There were two distinct ways to define stocks as a hedge against inflation, First, a stock was a hedge against inflation if it eliminates or at least reduces the possibility that the real rate of return on the security will fall below some specific floor value.

Secondly, it was a hedge if and only if its real return is independent of the rate of inflation. The result showed a direct one-to-one relationship between the current rate of nominal returns and inflation for Argentina and Chile.

Further tests were conducted to check for the effects of the leads and lags of inflation. Evidence of a direct relationship between current nominal returns and one-period inflation was also found. Results also show that significant influence on nominal returns was imposed by lags but not by leads of inflation.

### Is There a Correlation Between Inflation and the Stock Market

This result backs the claim that the past rate of inflation may contain important information regarding the future inflation rate. These significant results presented may show that a positive relationship between stock returns and inflation is possible during short horizon under conditions of high inflation. Boucher considered a new perspective on the relationship between stock prices and inflation, by estimated the common long-term trend in the earning—price ratio and inflation.

The study focus on the subjective inflation risk premium explanation by considering a present value model with a conditional time-varying risk premium and estimate the common long-term trend in the earning—price ratio and actual inflation. The study found that these deviations exhibit substantial out-of-sample forecasting abilities for excess stock returns at short and intermediate horizons.

The results presented indicate that the earning—price inflation ratio has displayed statistically significant out-of-sample predictive power for excess returns over the post-war period at short and intermediate horizons.

The results are ambivalent concerning the efficient market hypothesis. Rapach measured the long-run response of real stock prices to a permanent inflation shock for 16 individual industrialized countries by using recent developments in the testing of long-run neutrality propositions.

Under long-run inflation neutrality, an exogenous increase in the trend rate of inflation trend rate of money stock growth will have no long run effect on real stock prices.

However, some well-known theories suggested that an increase in trend inflation can bring about a long-run decrease in real stock prices.

## How does inflation affect the stock market?

The result found little plausible evidence for a negative long-run real stock price response to a permanent inflation shock in the countries to assume that the contemporaneous decrease in inflation in response to a productivity shock and the liquidity effect were large. The study also show the evidence that the long-run real stock price response to a permanent inflation shock was positive in a number of industrialized countries. The structural bivariate VAR approach found that a permanent inflation shock significantly increases long-run real output levels in some relatively low-inflation industrialized countries Austria, Finland, Germany, and the United Kingdom.

A long-run increase in real output should permanently increase anticipated earnings and thus real stock prices. The study found evidence against a long-run Fisher effect with respect to nominal interest rates on short-term government bonds for a number of industrialized countries Belgium, Canada, France, Germany, Ireland, Netherlands, United Kingdom, United States.

More specifically, the nominal interest rates typically increase less than one-for-one with inflation in the long run in response to a permanent inflation shock and thereby lowering real interest rates in the long run. Using a trivariate structural VAR framework, Rapach in press also finds that the long-run real interest rate typically falls in response to a permanent inflation shock for a large number of industrialized countries.

A lower long-run real interest rate on risk-free bonds should also increase long-run real stock prices by lowering the rates at which anticipated earnings were discounted.

Khil and Lee observed real stock return and inflation relations in the U. In the study, they document a negative real stock return and inflation correlation in nine Pacific-rim countries as well as in the U. However, Malaysia was the only country that exhibits a positive relation between real stock returns and inflation. Thus their study provided an empirical framework that attempts to disentangle the sources of these correlations. There were several reasons that they were interested in the stock return and inflation relation in the Pacific-rim countries.

First, it was become more important to understand financial markets in Asian countries. Second, while the U. Fourth, monetary authorities and their policies in most Asian countries tend to be more prone to political influence than in the U.

Fifth, one of the hypotheses that explain the negative correlation between stock returns and inflation was the tax hypothesis. But Malaysia experiences a positive correlation between stock returns and inflation. The result show the relationship between real stock returns and inflation appeared to be inconsistent with the predictions of the Fisher hypothesis and common sense that common stocks should be a hedge against inflation but was in line with the post-war experience of the U.

Malaysia was a country that exhibits a positive relation between stock returns and inflation. Second, the identification and decomposition analyses show that the interaction of real and monetary disturbances appears to explain at least nine countries observed stock return and inflation relation. In these countries, the real output disturbances drive a negative between stock return and inflation relation, while monetary disturbances yield a positive in stock return and inflation relation.

Third, Indonesia and Malaysia turn out not to follow the above-mentioned pattern of real and monetary disturbances. In Malaysia, both real and monetary components yield a positive relation between stock returns and inflation. In Indonesia, both real and monetary components yield a negative relation between stock returns and inflation. Kim and In investigated the Fisher hypothesis and its examination of the relationship between stock returns and inflation by using the wavelet analysis and hence examines nominal and real stock returns and inflation over the different time scales.

They also investigate the variances, covariance of nominal and real returns and inflation. Correlations and cross-correlations between nominal and real returns and inflation were calculated for the different time scales. On the other hand, the study also examines the long-run relationship between stock returns and inflation not only in nominal but also in real terms. The results of the regression analysis in the wavelet domain and the wavelet correlation show that the relationship was positive at the short horizon.

Another results indicated that in all regression analyses, real returns have a significant negative relationship with inflation except for the shortest time scale d1 and the longest smooth scale s7 in wavelet analysis. Lee reevaluate whether the stock return and the inflation relation indeed due to inflation illusion by reexamining the hypothesis using longer sample period of the US and international data. The inflation illusion hypothesis explained the post-war relation well; it was not compatible with some features of the pre-war relation.

A major problem is that while this hypothesis anticipates underpricing of stock prices with high inflation. Thus, the study observed the overpricing with high inflation in the pre-war period. This implies that although the mispricing component plays an important role in the stock market and inflation relation in both subsample periods. The result found the two types of stock return and inflation relations without imposing a particular permanent and temporary restriction on the two types of shocks.

The two regime hypothesis show positive and negative inflation shocks can be easily compatible with both pre- and post-war relations in the US. There were indeed two distinct forces in the economy in each period, and they drive the relation in opposite directions. The observed relations in the pre-war and post-war periods are consistent with the relative importance of these shocks.

The bivariate VAR identification found that there are two types of stock return and inflation relations in each developed countries. Researcher considered and the observed negative relations in these countries were again consistent with the relative importance of the two types of inflation shocks.

Hondroyiannis and Papapetrou studied the dynamic relationship between real stock returns and expected and unexpected inflation utilizing a Markov Switching vector autoregressive model MS-VAR. A Markov regime-switching model MS was employed to capture the structural breaks during the estimation period once the two parts of inflation are determined. The Markov regime-switching model has the advantage that it was able to capture the dependence structure of the series both in terms of the mean and the variance.

The results suggest that actual inflation does not significantly influence real stock market returns. Inflation was then decomposed into two components, one due to supply shocks permanent inflation and one due to demand shocks temporary inflation. The variables of this study are stand from interest rate U.

All the data are transformed into logarithms. The variables were initially tested for unit root using the Augmented Dickey Fuller test. This is followed by the Cointegration test to determine the number of cointegrating vectors. After determining the cointegrating vectors that shows the long run relationship between the variables, the short run relationship was determine using the Vector Error Correction Modeling. The Cointegration Test in the table shows the variables are co-integrated.

The Trace statistic value is lower than critical value at 5 percent significance level, indicating 1 cointegrating equations at 5 percent significance level. This means that there is a long run relationship between the two equation models above. The Trace statistic value is greater than critical value at 5 percent significance level, indicating 1 cointegrating equations at 5 percent significance level.

The Trace statistic value is greater than critical value at 5 percent significance level, indicating 3 cointegrating equations at 5 percent significance level. This indicates that variables expected inflation, exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run.

The sign of negative explained that there are found in expected inflation, exchange rate and interest rate to have negative impact on the stock market while GDP has positive impact on the stock market.

Based on this result, the expected inflation, exchange rate and interest rate are claimed to be substitute to GDP in influencing the stock market.

In addition, from the Coefficient value, it can be claimed that exchange rate has bigger impact than the others variables in influencing the stock market. For the table 4. Same as table 4. This indicates that variables exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run. The sign of negative in GDP explained negative impact on the stock market while Expected inflation, exchange rate and interest rate have positive impact on the stock market.

Based on this result, the GDP are claimed to be substitute to Expected inflation, exchange rate and interest rate in influencing the stock market. From the Coefficient value,it can be claimed that GDP In contrast, Table 4.

This indicates that variables unexpected inflation rate, exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run. The GDP explained negative impact on the stock market while unexpected inflation, exchange rate and interest rate have positive impact on the stock market.

Based on this result which same as result in table 4. The sign of negative explained that there are found in expected inflation and exchange rate to have negative impact on the stock market while interest rate and GDP have positive impact on the stock market. Based on this result, the expected inflation and exchange rate are claimed to be substitute to Interest rate and GDP in influencing the stock market.

The coefficient value claimed that exchange rate has bigger impact than the others variables in influencing the stock market.

The estimated t-value for Exchange rate In contrast, Unexpected inflation This indicates that variables exchange rate, interest rate and GDP are significant, while unexpected inflation is insignificant explaining the changes in stock market in the long run. There are found in exchange rate and interest rate to have negative impact on the stock market while unexpected inflation and GDP have positive impact on the stock market.

Based on this result, the exchange rate and interest rate are claimed to be substitute to unexpected inflation and GDP in influencing the stock market. Lastly, the coefficient value shows that exchange rate has bigger impact than the others variables in influencing the stock market. The error correction term 1 shows that the estimated t value of —0.

The F-statistic is 2. All variables in lag 1 and lag 2 for t-values, stock market 3. The error correction term 1 found in Table 4. All variables in lag 1 and lag 2 for t-values, stock market 2.

Because the Unrestricted Cointegration Test indicated 3 cointegrating equations, there are 3 error correction term. All variables in lag 1 and lag 2 for t-values, stock market Same as the Table 4.

Assume that the expected return of 5. 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.

If inflation goes up further, the higher the increase, the larger your losses will be in real terms. 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.