How does PPI / CPI Affect the stock market?
Posted by Harrison | Posted in Day Trading, Fundamental Analysis, Learn How to Invest, Stocks | Posted on 24-11-2006
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I came across this question in Yahoo! Answer and there is a great answer for this question with a simple explanation on the effects of CPI and PPI, here is the answer:
PPI and CPI are indices, for wholesale and consumer price inflation. Inflation is the natural enemy of the stock and bond market. Inflation, the rising of costs that companies/people have to pay and the hike in prices/wages that they have to earn in order to pay for higher costs, based on expectations.
Investors want to have the highest “real” return on their investment. Real return is nominal return less inflation. If you think that prices are going to going to rise next year by 5% and you earn 15% on a checking account, you do the quick math and know that you are going to earn about 10% real returns (15% minus the 5% inflation). You would keep a decent amount of money in the bank, because that is a great real return. Let’s say that prices are rising 1400% per year, like they are in Zimbabwe right now. You wouldn’t keep any money in your 15% bank account because your money becomes weaker (buys less and less goods and services) sitting in your bank account just through the passage of time.
The same thing happens with the stock market. The stock market prices in investors’ expectations of value of companies based on future real earnings. So the theoretical value of stocks decreases when inflation rises.
Inflation also has fundamental impacts on the underlying economy and companies themselves. The economy loses steam with inflation as people are less willing to put in deposits, which reduces liquidity resources for the capital markets, which spirals interest rate up for the debt market, which then raises costs for companies, which then causes more inflation… as the spiral of inflation goes up and up and up - all the while causing more volatility and less stability for investors/banks.
CPI and PPI are “lagging” indicators in that they look backward at how prices have changed on a basket of goods in the past. Monetary and fiscal policy takes about 6-12 months to filter through the economy. The stock market factors in future effects. Hence, when PPI and CPI is high, this may mean that the central bank (e.g. Fed, BOE, RBA) will have to hike overnight deposit rates in order to head off inflation 6-12 months down the road. The stock market is especially susceptible to inflation now since the market expects a rate cut (i.e. it factors in a decrease in rates in 2007 as shown by futures rates) and hasn’t had an overnight increase in a while. Continued CPI/PPI increases would be mean that there would be a sudden shift in perceptions that Central Banks would have to continue hiking to once again try and snuff out the spiral of inflation.
Source : Yahoo! Answer
