Inflation and indices: A negative correlation

A study shows that sales rise marginally in inflationary conditions, but profits see a sharp fall.

Apart from affecting a common man’s budget, inflation takes a toll on equity investments as well. The movement in benchmark indices has a negative correlation with inflation. So, when inflation rises, stock indices fall, suggests a study by Citi Investment Research and Analysis (Cira).

According to data for the past 10 years, annual inflation numbers have a negative correlation of -0.62 with the Sensex. The study showed that high inflation might lead to a nominal rise in sales but the impact on operating and net profits was quite negative. This is the reason stocks and equity indices have an inverse relationship with inflation, says Cira analyst Aditya Narain. The strategy, therefore, should be to base expectations on the movement of inflation. According to Cira, “If historical correlations largely hold, and inflation falls, sectors with the most upside will be information technology and auto (0.65), metals and energy (0.63), with banks close behind.”

Therefore, the next step is to work out where inflation is headed. There is a consensus that the rate will drop in the coming months. According to Frederic Neumann of HSBC Research, “In recent months, the wholesale price index (WPI) has proven to be rather stubborn. Though, we expect it to drop sharply over the second half of the year, as base effect works its tricks.” The key will be a good monsoon. Neumann pointed that last year, when the monsoon was poor, there was a two per cent addition to WPI. Lack of rain could prevent meaningful easing of inflation this time, he added.

Given this, policy makers would have to take a tough call on increasing rates to smoothen supply distortions. Neumann concludes, “It’s early days yet. The current monsoon in India looks better than last year’s, but so far isn’t quite as robust as we would have liked. This isn’t necessarily a problem for growth, but could weigh on the budget and keep inflation pressures elevated for a longer period. Rates still need to go up, rain or no rain, and even more so without.”