Draft:Stock Return and Inflation

In economics and finance, the relationship between stock market returns and inflation refers to stock market performance under various inflation environments. Stock returns are the gains or losses by an investor in a stock or a portfolio of stocks over a specific period. Such returns are influenced by a variety of factors, including corporate earnings, economic conditions such as the inflation environment, interest rates, and investor sentiment. The relationship between stock returns and inflation has been researched extensively, due to its significant implications for economists, policymakers, and investors.

Facts

The traditional view, according to the Fisher Hypothesis, suggests that stocks as claims on real assets should move in parallel with inflation. However, the empirical evidence has shown that the relationship is not always straightforward and can vary by country and across time. In the short term, equity prices tend to decline when inflation rises. For instance, stock prices dropped sharply around the world in 2022 following sudden inflation spikes. Researchers typically find negative correlations between real stock market returns and inflation. In the long term, however, stocks have historically provided a hedge against inflation risks.

Economic Reasons

The economic literature offers several explanations for the typically negative relationship in the short term.

One prominent theory that seeks to explain this relationship is the Inflation Illusion Theory, which states that investors misprice stocks during periods of inflation due to a misunderstanding of how inflation affects nominal and real values by sticking to historical patterns in new inflation regimes.

Another explanation is the Time-Varying Risk Aversion Theory, which believes that changes in investors' risk aversion over time can influence the relationship between stock returns and inflation. Risk aversion is the tendency of investors to prefer certainty over uncertainty, requiring higher returns to compensate uncertainty risk. This theory reasons that fluctuations in risk aversion, driven by inflation, can reduce consumption and equity prices.

Monetary policy is a key determinant of both inflation and stock returns. Central banks use tools such as interest rates, asset purchase programs, and forward guidance to achieve price stability. Central banks often raise interest rates to counter inflation, and higher funding costs lead to stock market falls. The exact degrees of influence is determined by monetary policy cyclicality, framework, and flexibility.

Taxes can substantially impact the realized returns investors obtain from their stock investments, especially in high inflation environments. In many countries, investors are taxed on nominal returns rather than real returns, meaning that taxes are levied on the nominal capital gains and dividends without adjusting for inflation. Inflation can increase the tax base for capital gains and dividends, even when real economic activity is stagnant or declining. In addition, depreciation based on historical costs amid rising prices translate into larger tax burdens.