A number of studies fail in finding evidence for real channels when trying to explain the negative correlation between inflation and real stock prices. In this paper I find strong support for real channels in Emerging Markets (EMs). In particular, I find that inflation is negatively related to earning growth rates. The results give support to the idea of inflation imposing real costs on the economy, as originally claimed by Friedman. At the same time, the findings cast doubt on the need to build on behavioural explanations, as initially suggested by Modigliani and Cohn (1979).
The literature has identified three real channels under which inflation negatively influences real stock prices. First, inflation impose real costs on economic activity as early papers by Friedman and Schwartz (1969) and Fama (1981) suggest. For example, inflation hampers intertemporal capital allocation (e.g. Aruoba et al., 2009; Chiarella et al., 2007; Brennan and Xia, 2002), or acts as a distortionary tax (e.g. Cooley and Hansen, 1989; Chari et al., 1996). If these frictions are present, inflation induces a decrease in future real earnings, driving the stock price downwards. The main empirical caveat is the almost complete lack of evidence supporting this channel. In some papers, the correlation between inflation and real earnings (dividends) is even found to be positive (e.g. for the US: Asness, 2003; Feinman, 2005; Campbell and Vuoltenahoo, 2002; and for emerging countries Spyrou, 2004). In this paper, I directly test the impact of inflation on real earning growth rates.
A second real channel works hand in hand with risk aversion and uncertainty: inflation correlates positively with risk aversion (Brandt and Wang, 2003); or risk aversion and uncertainty i.e. both the price and quantity of risk. Bekaert and Engstrom (2010) show that inflation is positively related both to risk aversion (they use a time-varying risk aversion measure based on Campbell and Cochrane, 1999) and uncertainty (they use the variance of next quarter GDP growth rate from the Professional Forecasters Survey as a measure of uncertainty).
I test these relationships in an indirect way. That is, I show that the correlation of stock prices and inflation is stronger during recessions, while the impact of inflation on real earnings does not impose significant variations in recessions when compared to non-recession periods. Also, I test for asymmetries conditional on the type of economic crisis: banking, currency and twin crisis.
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Inflation, Stock Prices and Real Earnings in Emerging Markets: Friedman Was Right
