Last month, the Reserve Bank of India (RBI) increased the benchmark repo rate to 6.5%. This led to a hike in bank deposit rates and government’s small savings rates. But did you know that changes in interest rates and inflation impact stock market investments as well.
Interest rates, inflation affect stock market investments
One of the factors that affects stock prices is expected earnings which, in turn, is affected by interest rates as companies operate with some borrowings in their balance sheet. If the repo rate continues to go up, banks will raise loan rates, sooner or later. This will lead to higher loan repayment cost for corporates. Rising costs reduce the net profit, which reflects in stock prices.
When this is applied to equity stocks in aggregate, it translates to a negative impact. Hence, when the interest rate cycle is on an upward trend, equities are unlikely to give high returns. The reverse happens when interest rates are cut.
Inflation is a situation of consistently rising prices in the economy. A growing economy like India is likely to have a certain level of inflation, but when the price rise is more than expected, it becomes a concern. RBI increases interest rates to stem higher-than-expected inflation or rise in prices of goods and services. Higher rates increase the costs in the economy and reduce overall spending, bringing down demand and, hence, slowing price rise.
Other than its influence on interest rate policy, which can impact stock prices, inflationary prices also affect corporate revenues and profit. However, the precise impact on revenues is hard to ascertain given other factors like volume and impact of inflation on raw material prices.
Also, inflation takes away from your annual purchasing power. If the inflation is 5%, then your ₹100 at the end of the year will be worth ₹95. Hence, when calculating your real return from investments, always consider the impact of inflation. Say, you expected a 12% annual return from equity and the inflation is 5%, then your real return is 7%. Similarly, if your fixed deposit gives 8% per annum, the real return net of inflation will be 3%.