What’s the relationship between inflation, crude oil prices and markets? It’s complicated!

Inflation, rising interest rates and crude prices have caused market declines in both equity and bond markets globally. There is no shortage of opinions linking high inflation/interest rates with low market levels. But is the negative relationship as straightforward as we think? Could there be room for nuance? The best way to answer these questions is to study past episodes of inflation and crude flare-ups and their impact on markets. Let’s start with inflation.

Inflation and equity
We analysed data on the US stock market and its correlation with CPI inflation stretching across 53 years, which included the dreadful 70s when the oil price shock and stagflation torpedoed economies. Inflation averaged 7.8 per cent between 1970 and 1982.

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Surprisingly, US indices didn’t suffer as much as we thought. The S&P500 Index rose by an annualised 3.3 per cent over that period – a small rise but still a positive return against heavy odds. Post-1982, inflation remained mostly benign, leading to a 9.5 per cent annualized return in US stocks. This is consistent with the low inflation – high equity valuation thesis.

However, there was a period from 1989-1993 when inflation once again spiked to 4.1%. But instead of falling, the US market delivered an 11% annualised gain during this period. How does one explain this? I guess it’s safe to say that the linkage between high inflation and negative returns is not so straightforward.

The relationship between Indian inflation and its stock market is similarly complex.

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There were periods (CY08-11) when inflation was accelerating and the Nifty index was falling (as expected), but during CY06 – 07, rising inflation was met with a rising Nifty.There were also instances when both inflation, as well as the Nifty index, were sliding. At minus 5 per cent, the statistical correlation between inflation and the Nifty index movement is negligible. But you wouldn’t have guessed that from the alarmist tone of media debates around inflation.

Crude oil and equity markets
The bear market narrative of the impact of high oil prices on equity markets is also quite inconsistent. Being import-dependent, India is vulnerable to oil price shocks. But data for the past 15 years shows a 57 per cent positive correlation between the Nifty’s moves versus oil price change. When we look at the US experience, there is again a positive correlation of about 37 per cent between rising crude oil and equity markets. This makes it hard to believe the commentators who predict weaker markets due to rising crude.

Interest rates vs stocks
Rising rates hurt valuations, bringing down share prices. Higher borrowing costs pull down corporate profitability and weaken consumption demand. Basically, rising rates are bad for the markets. Again, we trawled US market empirical data to ascertain the actual impact and found the correlation between rising 10-year bond yields (a proxy for rising interest rates) and S&P 500 returns to be a positive 14 per cent.

The Indian experience was no different. Between 2003-2007, bond yields and the Nifty rose in tandem, while they both dropped during 2015-16 – in stark contrast to the popular notion that interest rates and returns on shares move in the opposite direction. Statistically, there is a positive 42 per cent correlation between the two. This should make us think.


Contrarian strategy
Accepting stereotypes may seem like the easier option, but it’s worthwhile to look at alternative scenarios as well. India is speeding up while most global economies are slowing down. Despite high inflation, crude etc, equity markets have historically delivered the best returns. Investors need to look past the noise and choose wisely.

(Anil Sarin is CIO at Centrum PMS)