Impact of Inflationary Expectations on Stock Market

Summary

• Inflation expectations hold key significance in macroeconomics and can greatly alter the effectiveness of anticipated changes.
• Businesses may see a loss in profits during inflation due to rising capital costs which may hurt the stock market.
• Stock markets tend to react less adversely when inflation occurs during an expansionary phase compared to when there is a contractionary phase.

Inflation expectations, i.e., the rate at which inflation is expected to rise in the future by consumers, businesses, or investors, are important indicators of potential changes to the macroeconomic setup. In Keynesian economics, household expectations regarding inflation are key components in major models, however the importance of these expectations stretch out to the financial markets as well.

When these expectations are realized, the reaction of stock markets has been historically recorded to be somewhat distorted. However, when inflation is unexpected, the stock markets are not able to adjust to this unanticipated increase. Therefore, many experienced investors keep an eye out for any signs of rising inflation.

The reason that expectations hold an importance is because they bring in a reaction even when an envisioned policy or move has not yet taken place. The expectations alone alter the course taken by the market even before it has had any chance to experience a price increase.

Early Signs of Rising Inflation Expectations

Households and businesses form expectations based on the prevalent economic scenario and the government policies in place. Often, individuals change expectations when a new policy is rolled out. However, calculating these expectations remains somewhat of a grey area. Most sophisticated economic models that incorporate inflationary expectations measure them through household surveys, surveys of professional forecasters and market price-based measures.

It is important to note that these expectations are largely dependent on past records of inflation. For instance, if the central banks adopt a move to keep interest rates low, most people will adjust their inflationary expectations on the downward side. But if there is increased influx of capital through government policies, these expectations would see an upward adjustment.

Similarly, signs of economic recovery are harbingers of inflationary expectations. People become optimistic as economic activity gathers pace. This optimism flows into their consumption patterns which alter the course of the economy when viewed through a macro perspective.

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On the Cusp of Recovery and Increased Growth

Inflation expectations remain heightened when an economy is coming out of its recovery phase. The period moving from recession to boom is market with rising levels of inflation. This knowledge helps build increasing inflation expectations during the end of the recovery phase.

Most economies around the globe are currently at or around the last leg of their recovery phase since the pandemic begun last year. Australia boasts of having successfully come out of its recovery phase and aims to achieve pre-pandemic levels of economic activity.

This phase marks the onset of rising inflation expectations, especially with favorable government policies in the backdrop. Increased liquidity provided by fiscal and monetary policies solidify people’s optimism for the upcoming days. Improvement in economic indicators like the level of employment instill a deeper sense of confidence in people allowing them to shift their focus from savings to consumption.

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Stock Market Response

Increased inflation expectations can be red flags for stock markets. Most companies do not enjoy the idea of increasing prices. For the business sector, the possibility of upcoming inflation is an indication of rising capital costs. This is precisely why stock markets have little to gain from inflationary expectations.

Due to many moving parts in the process, stock markets can be hard to read especially when there are  many different types of companies involved. However, when inflation indicators change, investors and consumers adjust their expectations. This alters their buying or selling pattern. Thus, expectations cannot be discounted while considering stock markets.

Historical data also suggests that the stock market reacts more firmly when the inflation occurs during a recessionary phase as compared to when it occurs during a boom phase or is expanding. An expansionary phase may allow businesses to recuperate their inflation-induced losses by earning higher profits. However, during the contractionary part of the business cycle, firms are tied between declining profits and inflationary pressure. 

Historical Evidence

Most experts fall back on market indices like the Dow Jones Industrial Average and Standard and Poor’s Russell 500 and Russell 2000 to tap the reaction of the stock markets. These indices are representative of certain parts of the market. For instance, the Dow Jones Industrial Average (DJIA) represents the top 30 biggest countries in America. For Australia, S&P/ASX 20 represents the top 20 largest companies by market capitalization, while the S&P/ASX 200 is a market-capitalization weighted index comprising of top 200 stocks.

Historical reports of these indices suggest that most have them receive a negative impact when there are inflationary expectations in the market. The impact seems more pronounced on the smaller indices that account for only a small fraction of the entire stock market. Broader indices like the ASX All Ordinaries Index or the Russell 2000 fail to capture a strong effect.

Also, growth stocks may not appear as ostentatious during inflationary periods than they usually do. These stocks end up getting hurt the most since the offer returns in the future and inflation adversely affects those potential gains. On the contrary, value stocks are a haven for investors during inflation. Value stocks bring in the roughly the same amount profit making it easier for investors to rely on them.

Thus, there is no direct answer to how much of an impact to the stock market is brought along by inflationary expectations or even by inflation itself. Investors must investigate the possible impact of increased prices in the industry of their interest. That could potentially shed light on how stocks in that industry would react.