Inflation and equity prices

To evaluate the impact of inflation on stock market performance , investors frequently draw on experiences in the immediate aftermath of the two World Wars. In Europe, these periods were marked by drastic currency depreciation. However, stockholders at the time were far less affected by inflation and currency reforms than were (for example) holders of fixed-income securities or cash, some of whom lost all of the money they had put up. Are stockholders, then, protected against inflationary risks? At first sight, economic logic suggests that they might be. After all, rising prices mean higher corporate sales revenues and - provided costs do not rise even more sharply - higher profits. It is often pointed out in this context that a share is based on an underlying physical capital stock, which is a real entity and has a value that cannot be eroded by inflation. The nominal value of the company should, therefore, rise in line with general price rises. In short, this would mean for the present line of argument: Given that shares refer to real capital and the (real) earnings opportunities derived from it, price rises should drive up both earnings per share and share prices in equal measure. In this case both future dividend payments and share prices - in other words the "redemption value" - would be inflation-proof as a result of the adjustments to price inflation. However, past experience shows that this is not always the case, and it is therefore worth taking a critical look at this argument. No one would deny that, over very long horizons (e.g. about one hundred years), there is a high degree of correlation between price indices on the one hand and profits and stock indices on the other, i.e. that they move in line with each other. However, the situation can be quite different over the short and medium term (e.g. within a ten-year period). In fact, the violent economic fluctuations of the seventies, eighties and nineties were accompanied by an inverse relationship between inflation rates and stock market performance. This article sets out to examine the relationship between inflation and share prices systematically, focusing on the following stages: the impact of inflation first on corporate profit margins and profits per unit, second on economic growth, and third on the risk premium for shares.download