How does inflation affect the share market?

author-avatar By on July 20, 2021
How does inflation affect the share market?

With US inflation at 30 year highs, there are growing concerns it could spell bad news for share markets worldwide.

While US inflation hits near-30 year highs, hitting 5.4% in June, Australian inflation remains stagnant, despite a raft of measures the Reserve Bank has introduced to boost it and wage growth. 

Head of portfolio management Australia at State Street Global Advisors, Bruce Apted, noted heightened inflation could force central banks' hands to raise cash rates, which would prove volatile for share markets.

"As inflation trends higher central banks are often forced to tighten and this often flows into more volatile equity markets with lower returns," Mr Apted said.

"In the last 50 years the average rolling 12 month return for equities during periods of rising inflation was only 5.3%, compared to 10.4% return when inflation was trending down. A reminder that inflation trending up is a major risk factor for equity market returns."

What's the RBA doing?

Minutes released from the Reserve Bank Board's monetary policy meeting earlier in July revealed some of the Board's stance on global markets. 

"Members commenced their discussion of developments in international financial markets by noting that markets had interpreted the communications from the US Federal Reserve in June as being less dovish than expected," they said.

"Equity markets had remained around their recent record highs in most major markets, and conditions in corporate bond markets remained highly accommodative. Overall, financial conditions remained very accommodative."

However, the minutes also revealed some of the views about global inflation and how central banks can respond.

"A tighter labour market would be required to overcome the inertia in wage- and price-setting norms and the focus on cost control established over much of the prior decade in Australia," Board members said.

"Across advanced economies, central banks had continued to emphasise that near-term inflation pressures were likely to be temporary and that they remained committed to providing significant monetary policy support until there was evidence of sustained progress towards their inflation and employment goals."

The unemployment rate fell to 4.9% in June, the lowest level in a decade, while the RBA has maintained its 2024 guidance on its 0.10% cash rate.

Board members also agreed to reduce the Bank's bond purchasing program (quantitative easing or 'QE') to $4 billion from $5 billion per week, which affects headline inflation and bond yields.

Last week, New Zealand's Reserve Bank announced it would end its own QE program, preluding a potential 2022 rate hike, while Canada also tapered its QE program to CAD $2 billion per week.

Still, however, there remains questions in share markets, according to Mr Apted.

"We know that inflation is a lagging indicator and by the time we see actual inflation trending higher (as we do today) the markets will anticipate an ever increasing chance of tighter monetary conditions," he said.

"This is now one of the major debates within markets and so far this year we have already seen interest rate markets price an increased chance of some monetary tightening."

"As inflation continues to trend higher the balance of risks move to less accommodative monetary policy and a more volatile equity market."


Image by Frank Busch on Unsplash

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Harrison is Savings.com.au's Assistant Editor. Prior to joining Savings in January 2020, he worked for some of Australia's largest comparison sites and media organisations. With a keen interest in the economy, housing policy, and personal finance, Harrison is passionate about breaking down complex financial topics for the everyday consumer.

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