High inflation and rising interest rates have mixed effects on equities. Everything will depend on the type of business the company is in, and in particular its ability to raise (or not) the prices of its products or services, and its level of debt.
Inflation began to take hold in France in the summer of 2021. It averaged 4.9% over 2023, compared with 5.2% in 2022, when the average figure from 1999 to 2020 was 1.4%. Inflation should continue to fall in 2024. However, while INSEE forecasts inflation at 2.6% year-on-year in June 2024, it could in fact be around 3.4% as an annual average in 2024.
This is because the loss of productivity associated with wage increases will continue to push up companies’ labour costs. Geopolitical tensions (conflict in the Middle East, unrest in the Red Sea, escalation between Russia and Ukraine) are once again heightening the uncertainty surrounding oil and gas prices. Attacks on commercial vessels are already pointing to a further surge in shipping rates in the coming months, which could slow the decline in production prices, and to disruptions that could lengthen delivery times. Finally, the cost of the ecological transition and the desire to regain industrial sovereignty are generating inflation.
Inflation will therefore not disappear in 2024. With a few exceptions, prices should continue to rise. This inflationary context will delay the cut in key ECB interest rates towards the end of 2024, pushing up bond yields.
The rise in bond yields has several impacts. Firstly, borrowers (governments or companies issuing bonds) see the cost of their credit rise. For investors, bond yields are rising. Yet bonds are often less risky than equities. However, if the return on equities remains the same, the risk premium is said to decrease: the difference in remuneration between a risky asset and a less risky asset decreases. In this type of situation, some shareholders sell shares to invest more in bonds. If the movement is widespread, share prices may undergo corrections. Listed companies quickly have to adapt and reward risk with higher dividends.
For a company, increasing dividends is possible if profits are high. However, this can be complicated when inflation takes hold, as companies have to cope with rising raw material costs, labor costs and debt costs. If companies are unable to pass on all these increases in their selling prices, their profits fall. This holds them back from increasing their dividends. This has a negative effect on their stock market valuation.
At the same time, listed banks may suffer from the loss in value of their bond portfolios. To combat inflation, central banks have raised their key interest rates. New bonds are issued at higher rates than old bonds. Older bonds see their face value fall because their yield is lower. Investors prefer newly issued bonds. As interest rates rose very quickly in 2022-2023, the value of old bonds, in which banks had invested a large proportion of their liquidity, fell sharply. This led to major market shocks, notably in March 2023 when Californian banks had to sell their portfolios at a loss to meet their customers’ demands for withdrawals. These market shocks may recur at regular intervals as long as central banks do not cut key interest rates, making it even more difficult for listed companies to maintain their stock market valuations.
In this environment, companies that have little recourse to borrowing fare better than those with a lot of debt. Their costs are less affected by the higher cost of credit. As a result, they generate better margins and see their value rise faster on a stock market in search of reassurance.