HOW INFLATION & DEFLATION IMPACT FINANCIAL MARKETS
01 Sep 2022
What is Inflation?
The term “inflation” refers to an increase in prices, which over time results in a loss of buying power. The average price rise of a basket of chosen goods and services over time can be used to determine the pace at which buying power is decreasing. A unit of money now essentially has less purchasing power than it had in earlier times due to the increase in prices, which is frequently stated as a percentage.
How does the market react during Inflation?
Since it takes businesses many quarters to be able to pass on greater input prices to customers, the quick spike in inflation is typically regarded as the most severe. Customers also experience an unanticipated “pinch” while purchasing more expensive goods and services. But ultimately, both companies and customers adjust to the new price situation. Because currency loses value over time due to inflation, these customers are less inclined to keep cash on hand.
Corporate profitability may suffer from rising inflation due to increasing input costs. As a result, businesses become fearful about the future and cease employing, which lowers people’s quality of life, particularly for those on fixed incomes.
As a result of the economy and stock prices not being affected by inflation at the same rate. Individual investors must sort through the uncertainty to decide how to invest during inflationary times since there is no one correct solution. Certain stock categories often perform better when inflation is high.
What is Deflation?
The nominal costs of products, services, labour, and capital decrease during a time of deflation, even though their relative prices may remain the same. For many years, economists have been particularly concerned about deflation. Consumers gain from deflation on the surface because they may eventually spend the same amount of money on more products and services.
How does the market react during Deflation?
- Stock’s Market: Most people concur that deflation has a detrimental effect on equities since reduced prices over an extended period of time have a tendency to harm corporate net income’s bottom line. The issue might be made worse by deflation, which would push people to cut back on consumption and conserve money. Top-line revenues are negatively impacted by this approach as well. Shareholder value is diminished.
- Government Bonds: While deflation is negative for equities, it can be advantageous for some kinds of bonds. Government debt, such as that traded as U.S. Treasury Bonds, is more valuable because fixed payments are valued more highly. This occurs as a result of the fact that interest rates tend to drop during a deflationary era, which raises bond prices and improves profits for bondholders.
- Corporate Bonds: However, not all corporate bonds benefit from deflation, particularly those issued by non-blue-chip corporations. Debt payments become increasingly difficult to meet each year due to inflation since they increase in price. Companies are placed in danger due to this since eventually, they won’t be able to pay their obligations.