Can higher inflation lead to higher earnings?

For earnings to do well, inflation needs to be in the right zone, albeit this zone is hardly predictable

Can higher inflation lead to higher earnings?
Morgan Stanley believes that we may be at the start of a new profit cycle.

Rising inflation is a matter of concern as it indicates a broad-based rise in prices impacting the common man’s pocket. A steep rise would impact household expenses thereby forcing people to cut corners, increase the cost of money which in turn will lead to a reduction in demand thereby slowing down the economy. However, many market experts have an alternative view to this theory and say that rising inflation can lead to a rise in earnings for corporate India. As corporate revenue growth is closely associated with nominal GDP growth, hence, bears a strong relationship with inflation.

Inflation and earnings

But if inflation is too high or too low, it can hurt earnings through myriad macro implications. For earnings to do well, inflation needs to be in the right zone, albeit this zone is hardly predictable. “If inflation gets too high (economy too hot), the cost of money tends to rise and eventually kill the investment cycle. Such a rise in inflation could also raise macro-stability risks or hurt terms of trade, leading to a loss of profits to entities abroad, which can further spoil the investment climate,” wrote Ridham Desai in a report co-authored by Sheela Rathi and Nayant Parekh of Morgan Stanley.

In fact, if inflation is too low, nominal GDP growth falls, thus hurting revenue prospects and hence profits. “In India, currently policymakers think a headline CPI of 4% balances risks and output. However, the fact is that India has sometimes hit this target over the past five years and not generated earnings,” added the report.

Forecasting earnings

Desai further added add that share prices are usually a step ahead of earnings forecasts. “Thus, they lead earnings and actually tell us where earnings growth is heading. While the excess performance of a portfolio comes in being able to successfully disagree with the market’s opinion, usually, the market is right or wise and hard to beat,” he said in a report.

The report added that there are infrequent occasions when the market goes wrong like it did at the peak of 2008 when it became overconfident, or at the trough of March 2020 when uncertainty distorted prices and valuations generated maximum returns.

Morgan Stanley’s proprietary Leading Earnings Indicator indicates that earnings growth for the BSE Sensex could be somewhere between +36% and -15%, with 95% probability. The gap between the two bounds of 51% is the widest in history. This underpins two things – one is the greater uncertainty in the current environment and we may be at the start of a new profit cycle.

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