Many times one hear analysts and people related to stock that inflation remains biggest worry for the markets, if inflation is high than chances are stock market will fall and under-perform. So the question is why stock market fears inflation, before looking for an answer one must know the term inflation which refers to general rise in prices of goods and services over a period of time. Stock markets are afraid of inflation because of three reasons –
- When inflation increases central bank of a country gets into action and increases the interest rates so as to control the inflation which in turn leads to higher rates for loans, and since most of the listed companies have debt in their balance sheet, the profit margins of these companies will begin to squeeze because of higher interest they will be forced to pay. Higher interest charges will take away the profits of these companies and it will lead to fall in earning per share of these companies and which eventually leads to fall in prices of these stocks.
- Another effect of increase in interest rates is that people begin to withdraw money from the stock markets and deposit it into banks which are offering higher interest rates on fixed deposits, because if rate of interest on fixed deposits are high, people will always go for deposits which are safe rather than stock markets which are volatile and risky.
- High inflation implies higher prices of commodities like steel, crude, copper etc…., which again is not good for companies which use these commodities as their raw materials. Due to higher prices of raw materials profit margin of these companies is under pressure, which again means lower profits.