Inflation is one of the most analysed and discussed macroeconomic indicators in the financial world. Understanding inflation is essential not only for investors, but also for economists and policymakers. Its impact on the capital market is profound and multifaceted, directly affecting economic dynamics and investment decisions.
One of the most immediate effects of inflation is its influence on consumer purchasing power. When prices rise, consumers’ ability to purchase goods and services decreases, which can lead to a slowdown in demand. This, in turn, affects expectations of economic growth, creating a cycle that can impact the performance of various industries.
Faced with a scenario of rising inflation, central banks often increase interest rates as a way of controlling the economic situation. Rising rates can increase the cost of credit, making loans more expensive for both consumers and companies.
This change in financial conditions not only affects the profitability of various assets, but also causes a constant reassessment of investment strategies. Each sector and company can react differently to changes in interest rates and operating costs, creating a complex scenario for investors.
Inflation is a significant source of volatility in the capital market and can affect the capital market in a number of ways. As investors reassess economic expectations and the risks associated with different asset classes, including financial instruments, property or raw materials, uncertainty can increase. This leads to a reconsideration of investment strategies, requiring investors to keep a close eye on changing economic conditions.
For investors who don’t want to be exposed to the risk of inflation, there are instruments for this purpose, such as index-linked bonds
As for expected returns, inflation can negatively affect investors‘ expectations about the future performance of companies, as a result of the reduction in consumers’ purchasing power, which means that, in order to compensate for the risk, they demand higher returns as a way of protecting their capital or investment, resulting in the revaluation of assets traded on the capital market.
As for capital costs and interest rates, in response to increases in inflation rates, central banks often raise interest rates to control this macroeconomic indicator, thus making loans more expensive, which can result in a slowdown in economic growth.
This has a direct impact on the capital market, as the cost of capital increases, thereby devaluing the price of key assets. In a deflationary scenario, central banks tend to lower interest rates, making the cost of capital more attractive and thus stimulating the economy to borrow and invest, which allows asset prices to appreciate.
The easing of interest rates by the Central Bank can stimulate the valuation of stock markets
For investors who don’t want to be exposed to the risk of inflation, there are instruments for this purpose, such as inflation-linked bonds. The US Federal Reserve (Fed) issues bonds of this nature, called TIPS (Treasury Inflation-Protected Securities), which adjust payments based on changes in the value of inflation.
By way of example, the recent interest rate cuts of 50 basis points by the Fed and 25 b.p. by the European Central Bank (ECB) in September are a reflection of how inflation affects the financial markets, with the yield curves of these economies shrinking in return for an increase in share market valuations.
In Mozambique, inflation has been decelerating steadily in recent months, standing at 2.45% year-on-year in September, the lowest it has been since October 2019, which prompted the Bank of Mozambique to continue relaxing its monetary policy and once again reduce the monetary policy interest rate (MIMO rate) to 13.50%, compared to 17.25% in January.
These interest rate cuts have led to a downward shift in the yield curve across all maturities, in line with the reduction in inflation, reflected in lower returns for investors in fixed-income securities, as well as lower costs for borrowers.
