At its last policy meeting, the US Federal Reserve unexpectedly raised its expectations for inflation this year and even brought forward the timeframe on when it will next raise interest rates. The so-called dot plot of individual member expectations pointed to two hikes in 2023. This move has rattled the equity market. A couple of months back also we saw US bond yields inching up and the global equity market going down. It is widely accepted that a loose monetary policy along with higher fiscal spending and higher pent-up demand has stoked inflation globally. Conventional wisdom says that higher inflation is negative for stocks because it increases the cost of production or service due to rising input cost.
Besides, it also reduces the expectations of earnings growth, putting downward pressure on stock prices. Moreover rising inflation also leads to rising interest rate. While valuing the future cash flows from equity, higher interest rate will lead to lower valuation of equity. The graph below shows the relation between inflation (CPI) and Nifty PE. It is clearly visible that as inflation increases, the valuation of the equity market measured by PE declines. Therefore, if everything remains constant, rising inflation will reduce the value of your equity portfolio.
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