The Relationship between Inflation and Stock Returns in a Small Island State: An Analysis

Purpose: This article lays out an analysis of the relationship between inflation and Maltese monthly stock returns, comprising of 139 observations. Design/Methodology/Approach: A series of statistical tests were used so that the final multivariate time series model – a Vector Error Correction Model, was fitted to the data. The model results were corroborated to the findings from the qualitative data and previous empirical evidence. Findings: Findings indicate that stock returns are positively influenced by the previous month’s returns and negatively influenced by inflation, where the latter factor takes 3 to 4 months to impact stock returns. Additionally, short-term interest rates and money supply seem to contribute indirectly to the negative inflation-stock returns relationship since both variables are statistically significant in explaining inflation. Long-term interest rates and industrial production variables are statistically insignificant in explaining both inflation and stock returns. Findings show that Maltese investors’ focus is on high dividend pay-out and capital preservation.