We have to consider several factors when making investment decisions, but one thing for sure: how will inflation change?
Original blog post (Hungarian) available at: Economania
We have to consider several factors when making investment decisions, but one thing for sure: how will inflation change? Our opinion about this is greatly influenced by what kind of news we receive about the current inflation. However, it is an unclear question in which direction the market changes in light of all this, and through which channels the inflation expectation influence the returns.
The value of a given investment is certainly significantly affected by future inflation, but there are several reasons for this. The same expected net payout will be less valuable with higher inflation, making it less valuable to invest, which is why we would expect a negative correlation between inflation and stock returns. However, it is worth keeping in mind that the value of a share is determined by the expected payments, which are generated by real assets, so it is believed that in the long term, the payments will increase along with inflation. Added to this, we can expect that there will be no relationship between inflation expectations and returns, but higher future inflation also represents a different risk. For example, the future interest rate policy of the central bank may become uncertain, which increases risks. On the other hand, due to rising inflation, the probability that the economy will fall into a deflationary trap decreases, which is positive news for investors. The question is how do investors react to these risks, i.e. how does the risk premium develop when inflation rises?
The article by Chaudharry and Marrow (2022) explores empirically the question of how stock prices react to the development of inflation expectations as a result of the aforementioned effects, and which channel plays a key role in the process. The article contains several novelties. First, it uses daily data. The daily development of inflation expectations is proxied by the difference between the yield of inflation-indexed and non-indexed government securities, which precisely gives the risk-neutral inflation expectation. Due to the low liquidity, the calculations are also performed with expectations derived from swap transactions, but their results did not show any significant deviation in any case.
The answer to the first question can be clarified relatively quickly: an increase of 1 basis point in 10-year inflation expectations is associated with an average increase of 11.2 basis points in stock returns on the same day, i.e., their price rises. But it is not only long-term expectations that matter: yields react somewhat even more strongly to shorter-term (5-year) expectations (11.4 basis points). With the exception of the 2008 crisis, this result can be considered stable since the 2000s, and stock returns responded to the increase in inflation to varying degrees, but always with an increase. Furthermore, the result is also robust in a cross-section: a positive correlation can be observed between the increase in inflation and stock returns in all industries.
The second question of the study is to what extent individual channels play a role in the effect of inflation on returns. To do this, the authors use observations on days when new inflation data is published by the Bureau of Labor Statistics. The current inflation data certainly has a substantial influence on inflation expectations (the variability of changes in inflation expectations is significantly higher on these days), but it does not contain any other fundamental information. The results described above do not change substantially, and the estimated effects are not followed by a correction later, so it can be stated that the current inflation indicator is treated as fundamental information by the market.
The authors examine the mechanism of action with a regression path analysis. First, a bivariate model is used to estimate the impact of inflation expectations on stock returns. In the second step, they also control for changes in real returns, thus extracting the effect of cash flow and the risk premium. After that, they also control for the expected increase in dividends, with which the authors get the effect of the risk premium. By comparing the three effects, it can be determined which channel plays a role in the evolution of share prices. According to the results obtained in this way, the increase in stock returns is caused by 2.6 percent of the real return, 15.6 percent by the cash flow and 81.8 percent by the risk premium.
When the inflation data is published, opinions about inflation expectations change strongly, as a result of which share prices rise. And the main source of this is none other than the decreasing risk premium, which results from the fact that the probability of falling into a deflationary trap decreases. However, since the deflation risk - for the time being - seems to be a thing of the past, it is quite possible that the relationship between inflation prospects and stock returns will change again.
References
Chaudhary, M. and B. Marrow (2022). Inflation Expectations and Stock Returns. SSRN Scholarly Paper 4154564. Rochester, NY: Social Science Research Network. DOI: 10.2139/ssrn.4154564. URL: https://papers.ssrn.com/abstract=4154564 (visited on Aug. 28, 2022).