Why does inflation hurt financial markets, especially bond traders and portfolio managers?

By Alioune Sao *

Among all the worries of traders and bond fund managers is inflation. In the financial ecosystem, the word “inflation” causes headaches. Inflation can destabilize an economy for a long time, and its spillover effects are particularly harmful to households, businesses and financial markets.

What is inflation?

When we see a general increase in prices, we are talking about inflation. We are currently facing an inflationary situation. The signs of global inflation were noticeable already from 2021, moreover, it was during this period that the American Federal Reserve System began to normalize monetary policy.

The Russia-Ukraine conflict has complicated the situation with the increase in food and energy prices. For example, in CĂ´te d’Ivoire, the price of a liter of high-quality unleaded gasoline fell from 735 FCFA to 775 CFA francs, and diesel from 615 to 655 CFA francs. The inflation rate in the WAEMU zone is currently 8.5% against 3.6% in 2021. According to the BCEAO, this acceleration is mainly explained by increases in international grain and energy prices, and to a lesser extent by increases in transport and housing prices.

Inflation therefore affects the purchasing power of households and, given that prices rise faster than wages, living conditions deteriorate.

Apart from its impact on consumers, inflation is a nightmare for markets. But how to explain the negative impact of inflation on the markets?

In principle, if prices rise, companies should see an increase in their turnover, which should have a positive effect on future dividends, but this is not exactly the case. The company will spend more to produce because the raw materials will be more and more expensive. In addition to this, there is also a decrease in household consumption, given the cost of living. Thus, companies will see a decline in their turnover and, in correlation, their profits.

If profits decline, it becomes a problem for investors. Numerous empirical studies (Fama, 1981; Geske and Roll, 1983; Kaul, 1987; Kim, 2003) have demonstrated a negative relationship between return on assets and inflation.

A company’s value to an investor is determined by its future earnings stream. But the higher the inflation, the lower the purchasing power of the shareholder will be. Each gain he receives will be worth less.

Let’s take an example to understand better. We will say that SONATEL will pay a dividend of FCFA 1,650 per share next year. If the inflation rate is 0, this 1,650 FCFA will have the same value both now and next year. I can also buy myself a shirt with this 1650 FCFA. Now let’s say that inflation has increased by 5%. The price of my shirt will also receive 5%. If inflation is 7%, the value of my 1650 FCFA will decrease again… And so on!

For fund managers, inflation is particularly worrisome for another reason: when inflation exceeds a certain threshold, central banks in turn raise interest rates to contain it. If inflation is too high, interest rates adjust to lower them. But how?

The interest rate reflects the value of borrowed money. So, when the interest rate rises, the value of the currency also increases. For a loan of 10,000 FCFA with an interest rate of 5%. At checkout, you will receive 10,500 FCFA.

But if the interest rate rises to 10%, you will receive 11,000 FCFA. In other words, your money is worth more. Therefore, central banks raise interest rates to control inflation.

But this mechanism has an echo in the bond market.

In times of inflation, investors expect higher interest rates on loans to governments and businesses. Thus, bond issuers must offer more attractive yields to find investors. Bond yields are rising. This growth is evident in the state securities market of UMOA-Titres. It is also seen in the Eurobond market, with the risk premium for African securities increasing. The risk premium for African sovereign Eurobonds reached 1,164 basis points in October 2022, up from 630 basis points a year ago.

It is a good transaction for those who invest in the market. For borrowers, this means more expensive credit, as in the case of a bank (issue of debt sustainability for issuing states). However, for investors holding older bonds with lower yields, this is harmless. As investors prefer to buy securities that offer better coupons, the value of their bad bonds quoted in the markets falls.

Inflation also affects Treasury bill rates. In fact, if the rate of inflation is higher than the rate on Treasury bills, the real return on these securities is negative, making them less attractive to investors.

There are categories of inflation indexed bonds. The most common are floating-rate bonds and Treasury inflation-protected securities. The market in the WAEMU zone is starting to see this type of product with the latest issue indexed to the Central Bank’s liquidity injection rate from Ivory Coast.

In summary, a general increase in prices can lead to a spiraling effect that leads directly to recession. It doesn’t just affect ordinary mortals who buy placali, bread and bus tickets; it also hurts listed companies and their shareholders. Therefore, investors do not sleep a night when it comes to inflation.

*About the author

Alioune SAO, who graduated with a Master’s degree in Banking and Financial Techniques, has more than 12 years of professional experience in the financial profession. Before joining EVEREST Finance as Director of Capital Markets, Alioune was Head of the Market Activities Department at SAO SGI Finance Gestion et IntermĂ©diation. He has gained solid experience as a Trader in the market, particularly through IMPAXIS Securities. Since 2020, Director of Capital Markets within EVEREST Finance, Alioune has participated in and structured numerous valuation and financing advisory missions in the context of capital raising, acquisitions and restructuring, securities issuance and placement, privatization and debt restructuring.

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