Can common stocks provide hedge against inflation? Evidence from SAARC countries.
Shah, Syed Zulfiqar Ali ; Nasir, Zafar Mueen ; Naeem, Muhammad 等
INTRODUCTION
The theory says that if stocks provide an effective hedge against
inflation then the effect of expected inflation should be compensated in
the form of nominal stock return. As Fisher Hypothesis (1930) concluded
that nominal expected return on a security is a function of expected
inflation rate as well as expected real interest rate. Bodie (1976)
worked on Fisher Hypothesis and found that actual nominal return depends
on expected and unexpected inflation rates and also it depends on
expected and unexpected nominal returns. According to Geske and Roll
(1983) a positive relationship exists between stock returns and
inflation, based on the assumption that securities represent claims on
real assets. When there is an increase in rate of inflation, it is
expected that prices of real assets will also rise, thereby improving
the value of securities representing a claim on such real assets. We
found that various studies in this area reported against the hypothesis,
showing a negative relationship between the two. However, certain other
studies support the theory asserting that the relationship existing
between stock returns and inflation is positive. While the negative
relationship between inflation and stock return is against the theory,
negative results have led to formation of hypothesis such as tax
augmented hypothesis. The tax augmented hypothesis states that when we
deduct tax from the stock returns, their relationship with inflation
tends to get negative as the quantum and rate of taxes also rise along
with inflation. This hypothesis also opines that initial researcher did
not consider the tax impact when they were empirically testing the
relationship between stock returns and inflation.
The goal of this paper is to examine the relationship between stock
returns and inflation in the SAARC countries and to examine whether or
not Fisher Hypothesis holds in SAARC countries. Our motive for carrying
out this study was the lack of consensus on the empirically relationship
between stock returns and inflation in the literature. While there have
been numerous studies in developed economies which tested the
relationship between the stock return and inflation like USA and
European countries and found negative relationship, some studies have
also reported positive relationship. To the best of my knowledge this
relationship has not been explored in SAARC countries; additionally this
study uses the most updated dataset. Many economists have held the
belief for a long time that real stock returns and inflation should be
positively, or at least non-negatively, related. Some authors
hypothesise that returns on security depend on expected inflation. But,
a lot of researchers have found that the returns on security do not have
a positive relation between inflation and return after the war in the
United States. Again, studies carried out in a number of developed
economies like European countries and other developed economies in rest
of world found negative relationship between security return and
inflation in the post war era. Some studies found that pre-war there is
a positive relationship between real stock return and inflation.
I believe that the most important aspect of this subject is the
region. So far no formal research has been reported on the relationship
between stock returns and inflation to verify the applicability of
Fisher Hypothesis in SAARC countries. Considering the particular
economic set prevailing in these countries, I felt that a formal
research could produce useful observations that could help economic
planners, investors and analysts understand the functionality of
investment climate in this region better. The fact that researches in
different parts of the world, and in countries in different stages of
development have yielded different results over different time periods
also provides a forceful reason for establishing the validity, or
otherwise, of an important economic hypothesis in this part of the world
in the current times.
Hence, I will say that there are three justifications for carrying
out the present research:
(a) the region (SAARC countries) that has hitherto not been covered
by any research in this aspect;
(b) the significance of establishing the validity of an important
economic hypothesis for the current state of economy in the region; and
(c) the insight into investment functionality that it can provide
to investors and economic planners.
LITERATURE REVIEW
The field of finance has some literature on the inflation and
equity returns. It is among the most important issues in the finance,
basically the hypothesis which is related to interest rate hypothesis
commonly known as Fisher Hypothesis. Fisher (1930) argues that nominal
interest rate is a function of real interest rate and inflation. In the
long run when expected inflation increases then expected nominal
interest rate also increases, leaving real interest rate unaffected.
When we transpose this hypothesis into stock markets it means stock
return should reflect relationship between stock returns and inflation,
i.e. an increase in inflation should lead to an increase in stock
returns. This hypothesis is also supported by the Bodie (1976) who said
security returns depend on expected nominal return and also unexpected
nominal return, and also on expected and unexpected inflation rate. The
idea that there should be positive relationship is given by the Geske
and Roll who said in 1983 that stock returns and inflation should have a
positive relationship because they represent claim on real assets. But
in the literature there is lot of evidence available which shows that
stock market performs poorly during inflationary times, failing to hedge
share prices against inflation. Reilly, et al. (1970) made a portfolio
of common stock and found that common stocks are not hedged against
inflation. Bodie (1976), Nelson (1976), Fama and Schewart (1977) and
Adams, et al. (2004) analysed the hedging properties of shares and found
that there is a poor hedging of common stock against inflation, not only
unexpected inflation but also expected inflation, thereby indicating a
negative relationship equity returns and inflation.
Moosa (1979) found that common stock as a group is not hedged
against inflation because other factors like uncertainty and income
effect also have an effect on the stock prices. Fama (1981) hypothesised
that there is negative relationship between inflation and returns. Day
(1984) obtained the negative results and contradicts the theory and he
argued that production function shows stochastic returns to scale this
is the reason there is negative relationship. Prabhakaran (1989) found
that equities have not provided a hedge against inflation. Erb, et al.
(1995) found negative relationship between realised inflation and
realised asset returns. Chatrath, et al. (1996) examine the study stock
prices, inflation and output there results contradict the theory. Foort
and Martin (1996) conducted the study whether real estate provides a
hedge against inflation or not they found real estate did not hedge
against inflation during the period. Tarbert (1996) found commercial
property has not been a consistent hedge against inflation during the
period of studied examined. Khil and Bong-Soob (2000) examine the
relationship between stock prices and inflation on ten pacific-rim
countries and on USA, found contradictory results against the theory
except the Malaysia where he find positive relationship. Francis and
Tewari (2011) obtained results which contradict against the theory means
there is no positive relationship between the two.
Firth (1979) studied on UK data and found that there is positive
relationship between common stock rate of return and inflation. Martina
(1998) studied on the stock market's rate of return and expected
rate of inflation and employed parametric and non-parametric test and
found over all positive relationship between stock returns and
inflation, they found mutual fund performance is through the whole
period in which study is taken Crosby and Otto (2000) find that
empirical results support the view that the long-run level of the
capital stock is invariant to permanent changes in the inflation rate.
Schotman and Mark (2000) conclude that common stocks can be a hedge
against inflation even they perform well when the inflation is
persistent in long time horizon'. Lee, et al. (2000) find the
fundamental relationship between stock returns and both realised and
expected inflation is highly positive. Choudhary (2001) conducted study
on the relationship between inflation and rate of return on stocks and
find that common stocks hedge against inflation. Rapach (2002) examine
the relationship between real stock prices and inflation and their
result show that inflation does not corrode the long run real value of
stocks means stocks are hedged against inflation. Luintel and Paudyal
(2006) found in their study that stocks and inflation have positive
relationship. Ding (2006) find the positive relationship between common
stock returns and inflation this was due to strongly procyclical
monetary policy, but they also found negative relationship between
common stock return and inflation but this was due to supply shock.
Hondroviannis and Papapetrou (2006) find that inflation does not
significantly influence real stock market return. Boucher (2006) find in
his study that a temporary deviation from this common trend exhibit
substantial out of sample forecasting abilities for excess returns at
short and intermediate horizons. Bekaert and Engstorm (2010) find in his
study that there is positive correlation is often attributed to the fact
that both bond and equity yields comove strongly and positively with
expected inflation. Alagidede and Panagiotidis (2010) studied on 6
African countries employing parametric and non parametric co integration
procedures found support for the hypothesis that common stocks hedge
against inflation. Akash, et al. (2011) found the positive and
significant relationship between stock market index and inflation.
Barnes and Boyd (1999) find mixed result in low to moderate
inflation economies there is no relationship between inflation and stock
return but in high inflation economies they found positive relationship
between inflation and stock returns. Kim and Francis (2005) also find
mixed result they find positive relationship between stock returns and
inflation at the shortest scale and the longest scale but they found
negative relationship at the intermediate scale. Kolluri and Wahab
(2008) examined the relationship between stock returns and inflation and
found inverse relationship between stock returns and inflation, found
positive relationship between stock returns and inflation during the
high inflation period. Liflong, et al. (2010) examine the statistical
relationship of stock return and inflation and show that in short term
UK stock market fails to hedge against inflation but in the medium term
there is mixed results. Lee (2010) found post war negative relationship
between stock return and inflation but after war there results supported
the theory that positive relationship between stock returns and
inflation in all the developed economies.
THEORETICAL FRAMEWORK
According to Fisher hypothesis there is a relationship between
interest rate and expected inflation. When it is assumed that real rate
of interest rate is constant then nominal return is demanded which is
the combination of forgone current consumption and reduction of
purchasing power of money which is measured by inflation. So Fisher
equation is
[R.sub.t] = ([E.sub.t-1])[[r.sub.t]]) + ([E.sub.t-1])[[pi].sub.t]])
+ [[mu].sub.t] ... ... ... ... ... (1)
In equation one [R.sub.t] is the nominal interest rate,
([E.sub.t-1] [[r.sub.t]]) is the expected real interest rate,
([E.sub.t-1][[[pi].sub.t]]) is the expected inflation. When we forecast
the inflation, the actual inflation rate may differ with forecasted
inflation rate. The inflation equation will become as
[[pi].sub.t] = [E.sub.t-1][[[pi].sub.t]] + [V.sub.1t] ... ... ...
... ... ... ... (2)
[[pi].sub.t] is the actual inflation rate, [E.sub.t-1] -
[[[pi].sub.t]] is expected inflation rate and [V.sub.1t] is the error
term which arise due to forecasting error. Similarly the real interest
rate equation become
[r.sub.t] = [E.sub.t-1] [[r.sub.t]] + [V.sub.2t] ... ... ... ...
... ... ... (3)
[r.sub.t] is the actual real interest rate, [E.sub.t-1][r.sub.t] is
the expected real interest rate and [V.sub.2t] is the error term which
arises due to the forecasting error. So the real interest rate equation
can be
[r.sub.t] = [R.sub.t] - [[pi].sub.t] + [v.sub.t.sup.*] (4)
[sup.*][V.sub.t] = [[mu].sub.t] - [V.sub.1t] - [V.sub.2t] ... ... ...
... ... ... ... (4)
EMPIRICAL MODEL
When we transpose the Fisher hypothesis into stock exchange it
means nominal return reflects real return and inflation. Assuming real
interest rate constant then it means when one unit change in expected
inflation there should also be one unit change in the stock return in
same direction. Then we can say that stocks provide a complete hedge
against inflation. The most basic empirical model or equation through
which we can check the relationship between stock return and inflation
is given below.
[DELTA][(Stock Return).sub.t] = [alpha] +
[beta][DELTA][(Inflation).sub.t] + [[mu].sub.t] ... ... ... ... (5)
Here change in Stock return is our dependent variable [alpha] is
the real rate of return [beta] is the Coefficient of inflation which is
our independent variable. [U.sub.t] is the residual error term. If there
is Unit Coefficient of inflation it means that stocks are complete hedge
against inflation. As both series are at different level of stationary
so we will employee the ARDL bounds test model. We will use the ARDL
model in this paper to check the relationship between inflation and
stock return is given below.
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (6)
This model shows which variable is significant and which variable
is not significant. So checking the long run relationship between the
two we will apply Wald Test. Here [beta](4) = 0 and [beta](5) = 0 will
be imposed coefficient restriction. We will also check short run
relationship between the stock return and inflation this task will be
performed by employing ECM test. The ECM equation is written below.
[DELTA][(Stock Return).sub.t] = [alpha] +
[[beta].sub.1][DELTA][(Inflation).sub.t] +
[[beta].sub.2][DELTA][(Inflation).sub.t-1] +
[[beta].sub.3][DELTA][(Inflation).sub.t-1] + ECM(-1) ... ... ... ... ...
(7)
Through this equation we will know the coefficient of ECM that how
much adjustment process occurs. It will tell us the disequilibrium of
previous month's errors or shocks will adjust back in the current
month.
DATA
Our data consists of stock price indices and consumer price indices
which is monthly data taken from SAARC countries namely Pakistan, India,
Sri Lanka and Bangladesh. Our data set covers a period starting from
Month 1 of 1993 and ending on Month 12 of 2011. We took the monthly data
because of the annual series is not available for a sufficient time
period to justify a meaningful analysis. This data set is taken from the
International Financial Statistics data base of the International
Monetary Fund. The stock indexes are composed of the most actively
traded stock in each country which represents the whole economy of the
country and consumer price indices are composed of the factors which are
most representative of the consumer goods and services which are most
actively consumed by the customer which means those fixed goods and
services that indicate the inflation.
Descriptive Statistics of Data
Average monthly stock return ranges between 4.46 percent for
Pakistan to 16/08 percent for Bangladesh, with India and Sri Lanka
falling in between. Descriptive Statistics also tells us about the
variability which is measured by the standard deviation. India has the
standard deviation of 29.21 and Sri Lanka has the 47.40 and other
countries lie between them. Table shows that the data is negatively
skewed. Average monthly inflation appears more stable than stock returns
as it has less standard deviation as compared to the stock return
inflation. Sri Lanka has 3.97 percent average monthly inflation where
Pakistan has 8.27 percent and other countries have the values between
them. Variability (standard deviation) ranges between 2.69 for
Bangladesh and 6.16 for Sri Lanka. Data appears positively skewed except
for Bangladesh which is a little bit negatively skewed. Graphic
representation of data is also discussed in Index which is at the end of
the paper. Graphic representation of data shows that there is much
variation in the stock returns: with high peaks and very low valleys.
However, when we draw the graph of inflation it shows little variation
in all countries included in the study.
Our decision is based on ADF at 5 percent significance level with
trend and intercept. If at 5 percent level of significance the ADF
statistics is less than critical values then we will reject our null
hypothesis which is that there is unit root in series. Rejecting null
hypothesis it means series is stationary and there is no unit root
problem. If ADF statistics is greater than at the 5 percent level of
significance value then we will do at first difference. Our data is
stationary at different level except Sri lanka which is not stationery
at same level means both series are stationary at level other
countries' data is stationary one series is at level and other is
at first difference due to this reason we will apply the ARDL.
RESULTS AND DISCUSSIONS
In all countries distributed stock return with lag value is
significant. It means it has an impact on the stock return. In the case
of India distributed inflation also impacts on stock return, meaning
India's stock return is affected by the inflation. But as it has
the negative coefficient it supports the result of Moosa (1979).
Pakistan and Bangladesh also have negative coefficient but insignificant
and the Sri Lanka has positive coefficient but this is also
insignificant. Stock return with lag value of all countries also has
significant results: it means this variable also impacts on the stock
return. Change of inflation with lag value in Pakistan and Sri Lanka has
positive coefficient which support the theory of Fisher hypothesis
(1930) but Bangladesh and India show negative results. In case of
Pakistan, inflation with lag value has a negative coefficient sign with
significant t statistics value but other countries do not show such
behaviour meaning their inflation with lag value is not significantly
related with stock return. Some countries show positive coefficient sign
and some countries show negative coefficient sign with inflation.
For establishing the long term relationship we used the Wald test,
applying coefficient restrictions of stock return and inflation with lag
value. Wald test shows significant result which means that there exist
long term relationship between stock return and inflation. For
determining the existence of short term relationship between stock
return and inflation, I applied ECM test which also shows that there
exists a short term relationship between stock return and inflation.
Firth (1979), Hondroviannis and Papapetrou (2006) and Akash, et al.
(2011) also found such results that there exists a long and short
relationship between stock return and inflation.
CONCLUSION
This paper examined the relationship between inflation and stock
returns. The Fisher hypothesis states that in perfect market stock
return should provide a hedge against inflation. As in the literature
there are more empirical studies which conclude that there is a negative
relationship between stock returns and inflation. In this paper we
extensively studied the data to determine whether inflation and stock
return have any relationship and to establish if investment in common
stocks can provide a hedge for protecting the investors against
inflation. Our empirical results show mixed results. In case of
Pakistan, India and Bangladesh, our research shows a negative
relationship but in case of Sri Lanka it shows a positive relationship.
However, our Wald test result shows relationship does exist between
inflation and stock returns in all countries.
Following could be the reasons for these results.
(a) Stock prices in SAARC countries in general and Pakistan in
particular do not reflect economic realities per se. They are influenced
by quantum of money available for investment at stock exchanges, rather
than the state of economy. Events like recent legislation in Pakistan
allowing black money to be invested in stocks can change the returns
with or without inflation being a cause.
(b) Stock prices do not reflect the replacement value of inherent
assets on which the stockholders have a claim. Again, inflation as
computed on the basis of consumer price index cannot always be seen as a
measure applicable to prices of long term assets.
(c) Stocks have a claim on assets but if a major portion of assets
are monetary assets, as in case of financial institutions and trading
companies, inflation actually erodes the value of assets. Hence a
negative relationship in stock returns and inflation must be expected).
Implications
There are three main implications of the empirically analysis of
this paper. Firstly, it contributed to the existing literature on the
great puzzle regarding the potential of investment in stocks to cover a
shield against inflation. Admittedly, it came up with mixed results as
indeed was the case with several other studies carried out in developed
economies. Secondly, we established that there was no empirical evidence
(and analysis) on this important area of finance and investment in SAARC
countries. Hence, this pioneer paper will hopefully make a major
contribution in the field of research on finance in SAARC countries.
Thirdly and perhaps most importantly, it will have significance for the
investors who want to know whether the stock returns provide hedge
during the inflationary regimes or not.
Recommendations
It is recommended for future research that all countries in SAARC
should be included for testing the relationship and sample period should
also be expanded as much as possible.
It is also recommended that future research in this area should
focus on a comparison between the developed economies and developing
economies in the same period of time.
[FIGURE 1 OMITTED]
[FIGURE 2 OMITTED]
[FIGURE 3 OMITTED]
[FIGURE 4 OMITTED]
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Comments
Based on a single equation bi-variate time series model using ARDL
approach, the study analysed the efficacy of common stock investment as
a hedge against inflation. Study found that all SAARC countries exhibit
long run relationship between stock returns and inflation. The ECM
result also shows significance, over the short run. Nevertheless, some
critical observations are noted for improvement of the paper. First, the
paper does not progressively build the econometric model based on given
analytical framework. After simplifying the main returns equation, the
econometric model is stated suddenly in the form of regression. This
regression claims the underline behaviour relationships whereas
mathematical model used fisher equation which is actually an identity.
The point is: how an identity captures key behaviour among mentioned
variables? This needs to be justified. Secondly, a careful revision is
required to interpret key empirical results. In the present draft, a
number of disconnects can be easily found which causes confusion to the
reader.
Adnan Haider
Institute of Business Administration, Karachi.
Syed Zulfiqar Ali Shah <
[email protected]> is Assistant
Professor, Faculty of Management Sciences, International Islamic
University, Islamabad. Zafar Mueen Nasir <
[email protected]>
is Chief of Research, Pakistan Institute of Development Economics,
Islamabad. Muhammad Naeem is MS Scholar, Faculty of Management Sciences,
International Islamic University, Islamabad.
Table 1
Stock Return
Country Mean Std. Skewness Kurtosis
Deviation
Pakistan 4.463333 40.31947 -0.574711 3.972876
Sri Lanka 11.24477 47.40104 -0.331345 27.74259
Bangladesh 16.08147 40.72773 -0.455828 4.583476
India 11.53868 29.21087 -0.251301 2.443019
Table 2
Inflation
Country Mean Std. Skewness Kurtosis
Deviation
Pakistan 8.271716 4.439506 0.917515 4.091729
Sri Lanka 3.972876 5.167649 0.447880 3.028043
Bangladesh 5.979706 2.693780 -0.211802 2.270731
India 6.857255 3.305509 0.638455 3.116359
Table 3
Unit Root Tests
No Trend No Trend
ADF PP
Level First diff Level First diff
Bangladesh
Return -4.04 *** -5.81 *** -3.04 ** -11.3 ***
Inflation -2.61 * -5.63 *** -2.68 * -12.0 ***
Pakistan
Return -3.71 *** -4.99 *** -3.003 ** -10.9 ***
Inflation -2.701 * -5.05 *** -1.9852 -12.8 ***
India
Return -4.23 *** -5.14 *** -3.163 ** -11.4 ***
Inflation -2.918 ** -5.64 *** -2.5771 * -9.92 ***
Sri Lanka
Return -3.57 *** -8.77 *** -8.54 *** -28.7 ***
Inflation -3.59 *** -5.34 *** -3.017 ** -11.7 ***
Trend and Intercept Trend and Intercept
ADF PP
Level First diff level First diff
Bangladesh
Return -4.26 *** -5.80 *** -3.134 -11.3 ***
Inflation -2.6017 -5.67 *** -2.6725 -11.9 ***
Pakistan
Return -3.811 ** -5.01 *** -3.0434 -10.9 ***
Inflation -2.7740 -5.04 *** -2.0564 -12.8 ***
India
Return -4.37 *** -5.15 *** -3.225 * -11.3 ***
Inflation -2.890 -5.63 *** -2.5654 -9.90 ***
Sri Lanka
Return -4.06 *** -8.79 *** -8.89 *** -28.7 ***
Inflation -3.605 ** -5.32 *** -3.0111 -11.7 ***
*** Shows that series is stationary at 1 percent, 5 percent
and at 10 percent.
** Shows that series is stationary at 5 percent and at 10 percent.
* Shows that series is stationary at 10 percent only.
Table 4
ARDL Result
Variable Statistics Pakistan Sri
Name Lanka
[DELTA](SR(-1)) Coefficient 0.2561 -0.2623
t-Statistic 3.9007 -3.8550
Prob. 0.000 0.0002
[DELTA](INF) Coefficient 0.2597 0.2813
t-Statistic 0.3013 0.1842
Prob. 0.7634 0.8540
[DELTA](INF(-1)) Coefficient 0.1115 1.3340
t-Statistic 0.1274 0.8631
Prob. 0.8987 0.3891
SR(-l) Coefficient -0.094 -0.4052
t-Statistic -3.946 -5.7687
Prob. 0.000 0.0000
INF(-l) Coefficient -0.595 -0.9900
t-Statistic -2.853 -1.7142
Prob. 0.004 0.0881
Variable Statistics Bangladesh India
Name
[DELTA](SR(-1)) Coefficient -0.2985 0.2342
t-Statistic -4.5583 3.4892
Prob. 0.0000 0.0006
[DELTA](INF) Coefficient 0.0712 -1.706
t-Statistic 0.0469 -2.4524
Prob. 0.9626 0.0150
[DELTA](INF(-1)) Coefficient 1.6393 -0.6691
t-Statistic 1.0769 -0.9422
Prob. 0.2827 0.3472
SR(-l) Coefficient -0.3202 -0.0646
t-Statistic -5.1984 -2.931
Prob. 0.0000 0.0038
INF(-l) Coefficient -1.0214 -0.2095
t-Statistic -1.7764 -1.0638
Prob. 0.0771 0.2886
Table 5
Wald Test Result
Null Hypothesis: C(4) = 0, C(5) = 0
Statistics Pakistan Sri Lanka Bangladesh India
Name
F-statistics 8.2054 13.6892 7.2072 4.9330
Probability 0.0003 0.0000 0.0009 0.0080
Chi Square 16.410 27.378 14.414 9.8660
Probability 0.0002 0.0000 0.0007 0.0072
Table 6
ECM Result
Variable Statistics Pakistan Sri lanka Bangladesh India
name
[DELTA] Coefficient 0.7303 0.0586 0.7213 0.9078
(SR(-1)) t-Statistic 4.1567 0.5627 3.2750 4.2908
Prob. 0.0001 0.5742 0.0012 0.0000
[DELTA] Coefficient 0.1711 0.1801 0.2510 -1.8781
(INF) t-Statistic 0.1981 0.1233 0.2560 -2.7733
Prob. 0.8431 0.9020 0.7982 0.0061
Coefficient -0.8751 0.4601 -2.207 0.5642
[DELTA] t-Statistic -1.0191 0.3160 -2.280 0.7024
(INF(-1)) Prob. 0.8431 0.7523 0.0236 0.4832
ECM(-l) Coefficient -0.5747 -0.7358 -0.618 -0.7772
t-Statistic -3.0301 -5.8980 -2.668 -3.4979
Prob. 0.0028 0.0000 0.0082 0.0006
