Investigation Into The Relationship Between Common Stock Prices And Inflation In Nigeria

Introduction

1.1 Background to the Study

There is no gainsaying that stock market performs a catalytic role of energizing anations economic growth and development. Hailstorm and Smith, (1996) and Nwude, and Agbo (2013) all strongly emphasized the need for nations to maintain sustainable stock market stability to ensure that all stakeholders make meaningful and attractive investment that could guarantee easy and faster divestment. Sustaining market liquidity highly rests on stable equity pricing which is greatly influenced by the purchasing power of the both domestic and foreign investors.

Investors’ purchasing power which is driven by the inflation rate at a given time in turn determines the level of market liquidity as well as market yield achievable from stock market. According to Fisher (1930) expected nominal returns on asset have a long tradition of equating to their expected real return as well as the ruling inflation rate in the economy which could translate to economic growth. Fieldstein, (1980) also noted that inflation generates artificial capital gain which is normally subjected to capital gains tax and the presence of tax liability ,as well as rising inflation can particularly engender adverse corporate growth and efficiency. Omotor, (2011) however argued that a rising inflation rate increases riskiness of asset investment consequently and advised rational domestic and foreign portfolio investors to always incorporate inflation effect when choosing equities as long term holdings due to their potential of hedging against inflation erosion of purchasing power as well as real return on investment.
Similarly, the work of Park and Ratti (2000) demonstrated that contractionary monetary policy shocks generate significant movements in inflation and expected real stock returns that go in opposite directions thereby causing output decline and in turn reinforces greater economic uncertainty .But some schools of thought however believe that product prices which go up during rising inflation tend to translate to increased profitability for companies as well as bullish stock market trend. They contend that stock market investment remains a potential long term hedge against inflation risk as revenue and earnings should significantly do rise at approximately same pace as inflation.

An inflated economy is considered as an economy of instability and to this end, investors tend to shy away from such economy. This is because inflation is not only a sign of instability, it is also a sign of more money pursuing fewer goods a variable that tends to affect the value of profit or returns.

The maintenance of price stability is therefore one of the macroeconomic challenges facing the Nigerian economy today. The coming in of President Buhari’s government in May 2015 has also been faced with the challenges of increasing rate of inflation as price of goods have short up by 300% between May 2015 and March 2016. Inflation can therefore be defined as rise in prices of goods and services over a specific period thus affecting the value of the currency of the host country like Nigeria. Obi, Nurudeen, and Wafure (2009) defined inflation as the persistent increase in general prices.

The rate of inflation has far-reaching implications for investment in the economy. It also discourages investment and borrowing as returns on investment has no significant value at this period since more money purchases fewer goods. Obi, Nurudeen, and Wafure (2009) contributed that higher rates of inflation reduces aggregate demand, production, unemployment, and trade deficits. On the other hand, a low and moderate inflation will encourage economic activity, particularly production which in turn will raise gross domestic product (GDP), reduce unemployment, and eases the balance of payment problems as more investment activities will be carried out in the economy.

Since early 1970’s, inflation rates in Nigeria have been highly unstable; the high inflationary change was in excess of 30 percent. This is evident in the high correlation of money supply growth and high inflation due to the fact that real economic growth is less in real term to money growth. This can be observed from the growth in money supply and some structural factors such as; supply shocks arising from famine, unfavorable terms of trade and devaluation of currency. Furthermore, Structural Adjustment Program (SAP) introduced by the government in the late 1980’s also accounted for the increase in the price level in the economy. Consequently, inflation in Nigeria has overtime responded to structural changes. These changes can be characterized into four periods based on the pattern and events that occur in that period (Ibrahim and Agbaje, 2013).

Corroborating this, Ross et al (2017) argue that, economist, businessmen and even politicians maintain that, some level of inflation are needed to drive consumption, and it is assumed that higher level of spending are crucial for economic growth. Keynes (1930) and Fletcher (1989) on their part believed that some level of inflation is necessary to prevent paradox of savings – whereby consumer prices are allowed to fall due to higher level of production being achieved during economic boom. Buttressing his point he noted that inflation makes loan repayment by debtors easier as they need to pay back less valuable money than they borrowed. This study therefore attempts to econometrically appraise the level and direction of flow interrelationship existing between inflation rates and stock market returns in Nigeria.

1.2 Statement of Problem

Price stability helps in determining when an economy is stable or not. Inflation creates uncertainty in the economy and makes both domestic and foreign investors unwilling to invest (Mobolaji 2008). Inflation impacts negatively on the savings ability of citizens and as a result, low savings leads to a fall in the demand for stocks and equities as financial wealth. This decrease in demand causes the price of equities to decline thereby reducing returns on equities and stocks (Joyce 2012). At the same time, the prices of stocks determine how capable the stock market allocates shares and equities based on preference and availability of market information. The increase or decrease in the price of stocks create uncertainty for the investors and in turn, affect the demand and supply of stocks (Omosola & Taofik 2013). Generally, increase in price level affect people’s investment decision which has a negative impact on the total returns on stocks in the economy at large. Past studies on this, observed that this situation is common in the Nigerian economy (Hoesli 2000 & Omosola 2013). The relationship that exists between inflation rates and stock returns has been examined by several financial economists around the world. However, the relationship has not been widely examined in the Nigerian Stock Market. More so that the stock market is an integral part of the financial sector; its performance is very vital to growth process of the Nigeria’s economy, given the current drive towards making the country’s economy less oil dependent. There is, therefore, the need to examine the impact of inflation on stock returns and its implication on investment in Nigeria.

1.3 Objectives of the Study

To examine the relationship between inflation and common stock prices

To examine the impact of inflation on stock returns and its implication on investment in Nigeria.

To investigate if common stock can be used as hedge against inflation.

1.4 Research Questions

What is the relationship between inflation and common stock prices?

What is the impact of inflation on stock returns and its implication on investment in Nigeria?

Can common stock be used as hedge against inflation?

1.5 Research Hypothesis

Ho: there is no significant relationship between inflation and common stock prices.

1.6 Significance of the Study

This study would be useful to the general public in updating their knowledge on the relationship between inflation and share stock prices. The outcome of this study would assist managers of different sectors of Nigeria economy to determine the influence of their operating economic on financial performance variations management of Manufacturing Firms in Nigeria. The study might help managers to identify the economic factors that affect the performance of their firms and further know how each factor threatens their efficiency.

One of the fundamental questions in finance, accounting and business administration is what are the factors responsible for firm performance variations? The firms’ competitive advantage, specific characteristics or rather economic performance has been rather limited. There are a number of previous studies at the international level on the relationship of macroeconomic variables on firm’s performance viz profitability, growth. Rexford and Daisy (2013), Athanasqlou (2008), Baum (2001), Damir (2009). However, to identify what constitutes good economic characteristics to justify a firm’s performance is being a very difficult task among researchers hence, responsible for differences in research findings. This study contributes to knowledge by establishing the consistence of the previous findings in an emerging economy like Nigeria.

It is also of relevance and imperative for practitioners to have adequate understanding and give thorough attention to the investigation of the effect of inflation on stock price in Nigeria. The findings of this study would strategically position consultants to provides cutting-edge consulting services into a thorough analysis in strategy planning with consideration to economic variables which inhabit systemic risk, through a clear understanding of nature and extent to which these variable influence firms’ performance.

1.7 Scope of the Study

This study was carried out on the relationship between inflation and common stock prices in Nigeria. The study utilized Inflation rate in Nigeria from 1995 to 2014 in executing the study.

1.8 Organization of Study

The study is divided into five chapters. Chapter one deals with the study’s introduction and gives a background to the study. Chapter two reviews related and relevant literature. The chapter three gives the research methodology while the chapter four gives the study’s analysis and interpretation of data. The study concludes with chapter five which deals on the summary, conclusion and recommendation.