Mastering stock market decision making in the face of inflation

Inflation is a global phenomenon, affecting economies across the world. While inflation rates may vary from one country to another, the general concept of rising prices and the impact on purchasing power are universal. 

In its simplest terms, inflation refers to the sustained increase in the general price level of goods and services over time, leading to a decrease in the purchasing power of money. 

The point-to-point inflation rate in Bangladesh is 9.74% as of June 2023 as against 7.56% in June 2022. And, the monthly average (12 months) inflation rate stands at 9.02% as of June 2023 whereas it was only 6.15% in June 2022. 

Inflation being an economic phenomenon that has a significant impact on various aspects of an economy, including the financial markets such as the stock market, the rising inflation rate in Bangladesh has profound implications for the investors and also for the fundamentals of the listed companies in the Dhaka Stock Exchange. 

Therefore, exploring the meaning of inflation, examining the main reasons behind its rise, and analysing how the businesses are affected by rising inflation can aid in efficient decision making by the stock market investors.

Inflation is typically measured using inflation rates, which represent the percentage change in the general price level of goods and services over a specific period. The severity of inflation can vary across different economies, and it can be classified into various types, including demand-pull inflation, cost-push inflation, and built-in inflation. Understanding these types helps to shed light on the underlying causes of rising inflation.

There are several factors that contribute to the rise in inflation rates. One of the primary reasons is increased consumer demand. When the demand for goods and services outpaces their available supply, it leads to an increase in prices. Factors such as higher wages or government stimulus measures can fuel increased consumer spending, resulting in a demand-pull effect on prices.

Supply chain disruptions also play a role in rising inflation. Disruptions in the supply chain caused by factors such as trade restrictions, natural disasters, or political instability can lead to shortages and increased production costs. As companies pass on these expenses to consumers, it results in cost-push inflation.

Fluctuations in commodity prices also contribute to rising inflation. Changes in the prices of essential commodities like oil, metals, and agricultural products can impact production costs for businesses. As the prices of raw materials increase, companies may pass on these costs to consumers, resulting in inflation.

Monetary policy and money supply are crucial factors in managing inflation. Central banks regulate inflation through their monetary policies. When central banks increase the money supply by lowering interest rates or engaging in quantitative easing, it can potentially lead to higher inflation rates and vice versa. 

We have seen that the Bangladesh Bank's recent monetary policy prioritises containing inflation and ensuring a favourable business environment. They aim to reduce aggregate demand while supporting productive sectors like agriculture, CMSMEs, large industries, import-substituting sectors, and services. To attain this goal, they have implemented a contractionary monetary policy stance and specific initiatives. 

This includes increasing the policy rates, such as the repo rate and SDF rate, to raise borrowing costs and limit CPI inflation. Additionally, they have introduced a market-driven reference lending rate for all bank loans to enhance competitiveness and provide a favourable lending environment for businesses and individuals.

However, due to the time it takes for households and businesses to adapt their behaviour, typically, a delay occurs between adjustments in monetary policy and its impact on economic activity and inflation. Therefore, stock market investors in Bangladesh should still remain aware about the effect of high inflation on the fundamentals of the listed companies and also on the market sentiment while taking investment decisions during this period.

One of the significant effects of high inflation is on the revenue and profit margins of companies. Inflation can impact a company's revenue and profit margins. Companies that are unable to pass on increased costs to consumers may experience margin compression, leading to reduced profitability. 

Inflation also influences consumer behaviour and spending patterns. As the purchasing power of consumers decreases, their spending habits change. Companies offering essential products or services with inelastic demand may be less affected, while those in discretionary sectors may experience reduced demand.

Debt servicing is another area impacted by rising inflation. It can affect a company's ability to service its debt obligations. If inflation outpaces interest rate increases, companies with fixed-rate debt may experience a decrease in the real cost of borrowing. 

However, variable-rate debt can become more expensive to service if interest rates rise to combat inflation. Companies with high debt levels may face challenges in managing their debt obligations.

Inflation can also impact stock market valuations and investor sentiment. Higher inflation rates may lead to higher discount rates, potentially decreasing the present value of future cash flows used in valuation models. Therefore, investors must make necessary adjustments to the discount rates they are using to value stocks.

At present, the global rise in inflation can be attributed to two significant events- the Covid-19 pandemic and the Russia-Ukraine war. These events have had far-reaching implications, contributing to the upward trajectory of inflation rates worldwide. 

The Covid-19 pandemic, with its widespread disruptions to supply chains and economic activity, led to increased production costs and reduced productivity in many industries. The restrictions and lockdown measures implemented to contain the virus resulted in supply shortages and higher transportation costs, all of which added to a lasting inflationary pressure. 

Furthermore, the Russia-Ukraine war has introduced geopolitical uncertainties that have ripple effects on the global economy. The conflict that has potential to disrupt key supply chains may anytime lead to further higher prices and increased inflationary pressures worldwide. 

Therefore, it is essential for stock market investors to understand that inflation rates must have significant implications on their stock selection and decision-making process. 

Understanding the impact of inflation on corporate revenues, profit margins, consumer behaviour, debt servicing capability, and stock market valuations are crucial in order to make informed decisions. 

Investors need to consider the potential effects of inflation on their portfolios and adjust their investment strategies accordingly. With careful planning and adaptability, one can effectively strive for success at the stock market in an inflationary economy.

Tanzina Ahmed Choudhury/Head of Capital Market Research, SBAC Bank. Illustration: TBS

Tanzina Ahmed Choudhury is the head of Capital Market Research and Portfolio Management, SBAC Bank Investment Limited