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Inflation and stock returns

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  • Samih Antoine Azar

Abstract

Stock returns, whether nominal or real, are commonly found to depend negatively on actual inflation, expected inflation and unexpected inflation. This runs contrary to the Fisher hypothesis generalised to apply to stocks, whereby stocks should be a hedge against inflation. However, another branch of finance, valuation theory, considers that the firm's equity is equal to the present value of future cash flows discounted at an appropriate market yield. Accordingly, if inflation is higher, the cash flows and the market yield are both adjusted upward, leaving the present worth unchanged. This present worth is the same if real (inflation-adjusted) cash flows are discounted at the real (inflation-adjusted) interest rate. Therefore valuation theory predicts that inflation is neutral on equity prices. This paper argues and presents evidence that this is indeed the case. When a fundamental variable, which is determined by a simple stock model, is included in the regressions, the effect of inflation on stock returns dissipates. Thus the observed negative relation between inflation and stock returns is due to a misspecification of the model. In reality, when the relation is properly formulated, inflation and stock returns are independent of each other.

Suggested Citation

  • Samih Antoine Azar, 2010. "Inflation and stock returns," International Journal of Accounting and Finance, Inderscience Enterprises Ltd, vol. 2(3/4), pages 254-274.
    • Handle: RePEc:ids:intjaf:v:2:y:2010:i:3/4:p:254-274
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    Citations

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    Cited by:

    1. Godfrey Marozva & Margaret Rutendo Magwedere, 2017. "Macroeconomic Variables, Leverage, Stock Returns and Stock Return Volatility," Acta Universitatis Danubius. OEconomica, Danubius University of Galati, issue 13(4), pages 264-288, AUGUST.
    2. Samih Antoine Azar, 2013. "The Spurious Relation between Inflation Uncertainty and Stock Returns: Evidence from the U.S," Review of Economics & Finance, Better Advances Press, Canada, vol. 3, pages 99-109, November.
    3. Samih Antoine Azar, 2014. "The US Dow and the US dollar," Applied Economics Letters, Taylor & Francis Journals, vol. 21(10), pages 683-686, July.
    4. Dodig,Ante, 2020. "Relationship between Macroeconomic Indicators and Capital Markets Performance in Selected Southeastern European Countries," Policy Research Working Paper Series 9323, The World Bank.
    5. Luo Wang & Bin Li & Benjamin Liu, 2017. "Can Macroeconomic Variables Explain Managed Fund Returns? The Australian Case," Economic Papers, The Economic Society of Australia, vol. 36(2), pages 171-184, June.
    6. Samih Antoine Azar, 2013. "US Stocks and the US Dollar," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 4(4), pages 91-106, October.
    7. Samih Antoine Azar, 2022. "Japan and the United Kingdom: The Inflation Irrelevance Proposition," International Journal of Economics and Financial Research, Academic Research Publishing Group, vol. 8(4), pages 123-128, 12-2022.

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