Inflation, Output, and Stock Prices: Evidence from Two Major Emerging Markets
Adrangi, Bahram, Chatrath, Arjun, Raffiee, Kambiz, Journal of Economics and Finance
Research in economics and finance documents a puzzling negative relationship between stock returns and inflation rates in markets of industrialized economies. The present study investigates this relationship for Korea and Mexico. We show that the negative relationship between the real stock returns and unexpected inflation persists after purging inflation of the effects of the real economic activity. Johansen and Juselius cointegration tests verify that the long-run equilibrium between stock prices and general price levels is weak. However, in both economies, stock prices and general price levels seem to show a strong long-run equilibrium with the real economic activity. (JEL E3 1, G 12)
The relationship between stock prices and inflation has been an intriguing anomaly for researchers. Equities in industrialized economies have failed to maintain their value during periods of high inflation. For example, during the rapid inflation years of the 1970s, U.S. stocks prices did not keep pace with general price levels. According to Fisher (1930) asset values should be positively related with expected inflation, providing a hedge against rising prices. If the implied positive relationship between stock prices and inflation does not hold, stock investors will be vulnerable to inflation, especially during rising economic cycles.
This paper investigates the relationship between equity returns and inflation in two emerging market economies, Korea and Mexico. Most emerging market economies were characterized by high and volatile inflation during the late 1980s. For example, the annual inflation rates among these countries ranged from a low of 0 percent for Panama to a high of nearly 3,400 percent for Mexico in 1989. The average annual inflation rate among thirteen major emerging markets was 627 percent in 1989, according to International Monetary Fund statistics. Given high inflation rates among these economies, and a rising interest by investors in international markets in general and emerging markets in particular, it is important to investigate the relationship between stock prices and inflation rates for these economies.
Korea and Mexico are selected here because they are at different stages of implementing market economic systems. While Korea is one of the first emerging market economies to introduce economic reforms in the mid 1980s, Mexican economy was mired in chaos during the "lost decade" of the 1980s. However, since the early 1990s the Mexican economy has been relatively healthy. Therefore, it is reasonable to assume that these economies represent two emerging economies at different stages of development. Furthermore, Mexico had a total of $157.2 and $129.6 billion of trade (exports and imports combined) with the U.S. in 1997 and 1996, respectively. The significant increase in trade volume from 1996 to 1997 was the result of NAFTA. This makes Mexico the third largest trading partner of the U.S. after Canada and Japan. The Republic of Korea had a total of $48.2 and 49.3 billion of trade (exports and imports combined) with the U.S. in 1997 and 1996, respectively, ranking it the fifth largest trade partner of the U.S.
The equity markets of Korea and Mexico have underperformed the mature markets of the developed economics.1 Inflation, a real threat in most emerging markets, seems to be currently in check in both of these emerging markets. While the equity indices in Korea and Mexico have soared from 18 and I in 1985 to 117 and 487 in 1995, respectively, the annual inflation rates of 0.3 percent in Korea and 3 percent in Mexico in 1995 are respectably low by any standards, particularly for emerging markets.' Despite these successes in curbing the inflationary threats, as events of Thailand, Korea, and other Pacific Rim economies in mid and late 1997 demonstrated, inflation and currency depreciation in these economies could occur with little warning and threaten the stability of equity markets and financial structure. …