Do Stocks Provide Hedge Against Inflation?

Investing in stocks certainly provide a natural hedge against inflation corroding the investment.

How come?

Historical data suggests that in the long term, meaning over 15 years, stocks give a return of over 15% compounded annual growth rate (CAGR). The BSE SENSEX which commenced its glorious journey on 1st April 1979 with a base value of 100 stands today, 8th September, 2016 at 29045. This translates into a CAGR of 16.57% in 37 years.

On the other hand inflation in India over the same 37 years stands at a CAGR of 8.17%. It is also to be noted that before the economic liberalisation in 1991 the inflation rates frequently used to be in double digits. However in the last 15 years governments have started taking inflation control seriously. Presently it is sought to be kept below 5% per annum.

From the foregoing it is clear that even after adjusting for inflation, stocks have given a real return of 8.40% CAGR, which is simply amazing. A sum of Rs.1,00,000 invested in BSE Sensex on 1st April 1979 would have become Rs.2,90,45,000 today!

In conclusion, there is no doubt whatsoever that stocks invariably protect the investment from erosion on account of Inflation.

What is US Federal Reserve and How will a Fed Rate Hike Affect the Indian Stock Market?

Every country has a central bank akin to our own the ‘Reserve Bank of India (RBI)’ to regulate the commercial banks and craft and implement the the country’s monetary policy. The ‘US Federal Reserve’ is the central bank of the US.

Central banks world over usually discharge following functions:

1. Regulate functioning of commercial banks in various ways.
2. Monitor and control liquidity in the economy by mopping of excess liquidity in the system (by borrowing, raising limits of compulsory reserves like CRR and SLR) and creating liquidity where there is a shortage (recent Quantitative Easing measures of the US is an example).
3. Determining the Interest Rates through the ‘Repo and Reverse Repo Rates’.
4. Monitoring and controlling ‘Inflation’ or ‘Price Rise’ through the different monetary measures discussed above.

Although stagnant or on a slight decline for a decade perhaps, the US still is a great nation. Even though her economy is not in great shape (the US today carries the highest external debt in the world), in the absence of a credible alternative, its currency remains the last resort in an increasingly turbulent global economy.

In an effort to revive her sagging economy, the successive US governments, aided by the Federal Reserve, have been implementing following stimulus measures:

1. Enhancing liquidity in the system through the most controversial and undesirable ‘Quantitative Easing’ or in plain words ‘Printing of Money’.
2. In order to boost investment, maintaining negative or ridiculously low interest rates.

Since fortunately or unfortunately the US continues to be the dominant global power, her actions, including those of the Federal Reserve impact the world economies and financial markets, including the Indian stock market as follows:

1. Excess Liquidity: Though meant for boosting domestic investment, cash invariably flows out and floods world markets. This results in a lot of money chasing a small number of stocks and other financial instruments. As per the latest study published by ‘Value Research’ an incredible 40% of the free floating shares of the Indian stock market is held by Foreign Institutional Investors or FIIs. This in-turn drives up valuations to absurdly high levels, making many goos stocks unaffordable to value investors.
2. Maintaining low interest rates for long periods of time adversely impact the interest incomes of majority of common population - ultimately affecting internal savings and investments, which was the goal of the measure in the first place! Additionally it aids the flow of money from the US to global markets, especially emerging economies like India, in search of better interest rates and other investment returns.

In this overall scenario, in the light of signals emerging from the the US economy that it is strengthening and realising in hind sight that the stimulus measures are hurting the economy the Federal Reserve is attempting a course correction by restoring healthy interest rates gradually.

Having covered the basics and understanding the background let us now address your question in the following paragraphs.

1. An increase in interest rates by the US Federal Reserve will have the impact of reversing the outward flow of liquidity. The FIIs will find it little more attractive to invest in their own home country. As a result they start selling their holdings in the world markets, causing a fall in stock prices globally.
2. In addition, an increase in interest rates at home will make the Dollar stronger and conversely the other countries currencies, including the Indian Rupee, weaker. This will force the hands of FIIs to sell immediately, as otherwise they will face a double loss:

• A loss on sale that is certain to arise by selling latter in a falling market.
• The currency exchange loss; when the Indian rupee depreciates, rupees 68 will fetch one dollar today will fetch less than a dollar after a week.

In the end, when the Fed increases rates, global markets will fall and liquidity in the global markets will reduce drastically. There is no doubt abiout this.

Real impact of market correction 

Is such a steep fall or deep correction of the Indian Stock Market good? Yes, it is really very good for the investors. Please note that excess liquidity chasing the small available floating stock has driven-up the valuations to unreasonable levels. While prudent investment guidelines prescribe a PE Ratio of 10 based on past five years earnings, the market today is trading at over 15 of expected, future earnings of the financial year 2016–17. As a result, real investors like you and I are unable to afford to buy shares at these levels.

In conclusion, the Indian stock market will correct on the back of the US Fed increasing interest rates, as and when it happens, and I as a value investor is eagerly looking forward to that day when I will be able to afford to buy many great Indian companies’ stocks like 'Infosys Ltd.', which I cannot afford presently.

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.

What Is Inflation?

Inflation could be a subject of a lifetime understanding for an economist. Thankfully, I am not one hopefully you are not one too, so let me explain in simple words.

Inflation means a rise in price level. For examole a kilogram of sugar was $0.50 last year and now it is let us say is $0.55. Let us also assume that prices of all other commodities remained unchanged. This means that not only the price of sugar has gone up by 10%, the inflation in the economy was 10%.

We can also say that the value of the currency, the $ in this case, has gone down by 10%, for while $0.50 could by 1 kg of sugar last year, it can buy only.0.91 kg now.

We have understood what is inflation, now let's understand whether it is good or not.

A low level of inflation is belueved to be good for the country and its economy. Why? Because prices rise when demand is high, which in turn means that incomes of people has increased making them demand more. However if inflation is very high it is not good for the people as theit currency is depreciating rapidly and becoming worthless.

No or negative inflammation suggests lack of growth, which means low income, less number of jobs etc., and hence not good for the country.

Therefore all governments and central banks constantly struggle for maintaining inflation at low yet positive levels of one to five percent, thereby ensuring a healthy balance between growth and currency stability.

Risk Comes from Not Knowing What You are Doing

Businessman jumping across the mountain taking risk

Driving an automobile is Not Risky; driving, without adequate training is – not only to the driver but also to all other unsuspecting road users, and that is why my Guru, Warren Buffett said, “Risk Comes from Not Knowing What You are Doing”.

Often I have heard people proclaim, sporting an, “I Know Everything” smile, that they diligently avoid investing in stocks, as it is Highly Risky.  On questioning how they had come to such a conclusion, they would invariably attribute the wisdom to their parents, teacher, colleague or friend. When questioned where they would prefer to invest, they would retort, with authority, “Corporate Fixed Deposits and Bonds – Rock Solid Safety”.  Sadly, after a few years, I have seen many of them Loose both Capital and Interest, and repent their poor investment decisions.

The moral of the story is, Risk or the Lack of It, does not lie in any particular instrument, but lack of knowledge.  A fixed deposit with a government bank in India indeed is as solid as rock, there is no doubt, but with an interest rate around 7% per annum and inflation near or above the rate of return, the “Value” of your investment is bound to be eroded for sure, over a period of 15 to 20 years.

On the other hand, if an investor had invested Rs.1,00,000 ($ 1470) in “NIFTY 50” in January 1995 and had simply forgotten about it, today in June 2016, it would have grown to Rs.809,400, a growth of 709% or a Compounded Annual Growth Rate (CAGR) of a whopping 32.99% per annum.  Even after an assumed, high, inflation rate of 10%, the investor would be left with a net return of 22.99%, Compounded Every Year!  So, Where Does Risk Lie? Not in the “Instrument”, certainly, but in “Ignorance”.