Nafisa Ali

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Stock market, going up by x%, down by y%, maintains its momentum – headlines like this is fairly common. Investors look for the stock market updates in newspaper first thing in the morning with a hot cup of tea. Recently, news on interest rate hike was a main factor influencing stock market volatilities in advanced markets. Empirically, interest rate and inflation have inverse relationships with stock returns and this relationship has been thoroughly validated in developed economies. So, how does it show in Bangladesh?

In an ideal economy, nominal stock returns are supposedly correlated in a positive manner with expected and actual inflation (Fisher, 1930). As a result, stock investment was considered a good hedge against inflation and validated in studies across multiple countries (Lintner, 1975; Firth, 1979; Groenewold, et al., 1997). However, inflation and real stock returns are negatively corelated as hypothesized by Fama (1981). The rationale provided by Fama is that a high inflation rate indicates low growth rate of real economic activity decreasing demand for real cash balances that subsequently increases future and current expected inflation. As high stock returns anticipate high growth rate of aggregate economic activity, inflation and stock returns are driven in opposite direction, hence the negative relationship. This means by nature, stock market is not a good hedge against inflation both actual and expected, especially in the short run (Bodie, 1976; Mandelker 1976; Nelson, 1976, Gallagher & Taylor, 2002). For a developed economy, interest rate increase indicates an increase in expected inflation. The interest rate goes up, the discount rate goes up and the stock price goes down since the present value of future cashflows will decrease. This shows an interesting interaction of stock market and inflation rate where real returns from investing in stock market is diminished by rise in inflation rate, especially if market incorporates expectation of inflation in a slow growing economy as is the case with developed, mature industrialized nations. Will this relationship be applicable for a fast-growing, developing economy such as Bangladesh?

In order to find the relationship between interest rate, inflation, and stock return in Bangladesh a simple correlation study has been conducted on monthly stock returns of 6 major industries (See Table below) across 5 years between January 2015 to March 2020. While there is a relationship between interest rate and inflation (as expected), there is no significant relationship between inflation with stock returns of any selected industries, although, average returns of most industries show significant positive correlation.

Pairwise Correlation Matrix Table

 

Interest Rate

Inflation Rate

Eng.

Food & Allied

Fuel & Power

Pharma &

Chem

Textile

Ceramic

Interest Rate

1

           

 

Inflation Rate

0.6403*

1

         

 

Eng.

0.1388

0.1003

1

       

 

Food & Allied

0.1044

-0.0765

0.6039*

1

     

 

Fuel & Power

-0.0349

-0.1473

0.4589*

0.4881*

1

   

 

Pharma & Chem

0.2193

0.187

0.4319*

0.4184*

0.3822*

1

 

 

Textile

-0.0872

-0.1459

0.5781*

0.5352*

0.5119*

0.1655

1

 

Ceramic

-0.124

0.0278

0.4686*

0.4050*

0.1263

0.1209

0.3908*

1

Note: * Significant Relationship at α=5% between Variables.

This result becomes more obvious when the data is observed graphically as shown above. The observation indicates that the volatility of stock return increases with inflation (risk increases), but the average stock returns do not clearly show any positive or negative relationship with inflation. Similar relationship was found with lagged inflation. The market is not interested in adjusting its expected return against the effects of inflation or increased risk at least in short run. Another words, the stock market is a bad hedge against inflation in Bangladesh at least in a short term as average stock returns are independent of changes in inflation rate. Interest rate also has no relation with the stock market whereas it has a significant positive correlation with inflation (statistically significant correlation, 0.6403*).  Potential investors, therefore, can use stock market as a hedge against uncertainty of inflation since fixed income securities and bank deposits will be significantly exposed to the value destruction effect of inflation.

In Bangladesh, people prefer to save money in banks rather than investing in capital market in order to minimize risks. However, the investment in fixed interest rate instruments such as savings accounts are surely exposed to a decrease in purchasing power during inflationary period. Bank’s adjustment of inflation in its interest payment on savings normally takes a significant lag. In this regard, investing in a portfolio of stocks that are good hedges against inflation will be a better alternative for money management. In particular, the expected inflation is due to expectation of upcoming economic growth investing in a portfolio of growth stocks can provide a hedge against inflation and riding with economic growth. Choosing inflation-hedge stocks is a simple exercise of probability concept using historical relationships between individual stock returns and inflation.

Our analysis highlights that the stock market in Bangladesh is at least not a bad hedge against inflation and certainly a better money management tool than leaving money in a bank deposit.

 

Disclaimer: This research report is for educational purposes incorporating researcher’s own opinion. BBS Research Center does not bear liability, however arising, for error, inaccuracy, incompleteness of fact, or any losses or damages which may arise from use of this research report.

For inquiries, please contact BBS Capital Market Research and Professional Development Centers, Capital Market Research Center (email: nafisa.easha@email.com)

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