There is no one-to-one correlation between the market and inflation. Typically, most investors stay away from the stock market when inflation goes up. This is because prices of shares along with the prices of everything else go up without any corresponding increase in intrinsic value. Such a bull phase soon leads to a market correction due to many investors deciding to realise profits.
One step most governments take to contain inflation is to tighten money supply by raising interest rates. This is because inflation is classically defined as too much money chasing too few goods. Once the money supply is tightened, the prices of commodities come down, thereby bringing down the inflation rate.
The increase in interest rates means investors will now find debt instruments such as fixed deposits more attractive than shares. This prompts investors to stay away from the stock market.
Inflation affects the stock price of different companies differently based on factors such as whether the company is export oriented, whether it manufactures goods that need to be used every day, or whether it manufactures high-end luxury goods for the domestic market.
The tight money supply affects different industries differently. For instance, a company that manufactures automobile parts for the foreign market will be adversely affected by the price hike due to inflation as it will not be able to increase its prices in line with the rise in its costs. This will affect its bottom line and in turn impact its share price negatively.
However, an FMCG (Fast Moving Consumer Goods) manufacturer will see an increase in revenue growth due to the inflationary prices and, hence, its EPS (earnings per share) and scrip price are likely to go up. However, it must be kept in mind that once prices fall, as they are bound to once inflation is contained, such companies will end up reporting a lower EPS.
A manufacturer of luxury goods for the domestic market (such as the makers of high-end cars) on the other hand might find its market size reduced as its products might find themselves priced out of the market. In this scenario as well the profits of the company and hence its share price is likely to be affected adversely.
An investor should, therefore, not be averse to allocate funds in his portfolio to shares, but instead pick the right company to avoid incurring losses during an inflationary period. Investors can also consider booking profits when the market goes up and wait for the correction to set in before buying shares once again. However, those who have invested for the long term should consider staying invested. Investing solely in debt funds will lead to a net erosion in the value of the corpus as the interest rates do not keep pace with inflation in the long term.