Relationship between inflation and stock performance: evidence from Kenya

Abstract

The relationship between inflation and stock performance has been a field of controversial study throughout the years. It was initiated by Fisher (1930) when he hypothesized that ex-ante nominal interest rate should fully predict movements in expected inflation in order to yield the equilibrium real interest rate. . This means that inflation should be independent of real stock return. This therefore proposes that stocks should therefore form a perfect hedge against inflation. However, further studies find an anomalous relationship instead. Studies find that there is a negative relationship between inflation and stock returns. Four main theories have been hypothesized to explain this anomalous relationship between inflation and stock performance; the proxy effect hypothesis, the tax effect hypothesis , the reverse causality hypothesis and the inflation illusion hypothesis. This paper tries to determine the nature of the inflation-stock performance in Kenya. Previous studies by Mutuku and Kimani (2013) find that this relationship is positive. The exact nature of the positive relationship is however unknown. The proxy effect hypothesis is test on the Kenyan economy in order to determine whether or not it can explain the anomalous relationship. This consequently determines whether or not inflation does form a hedge against inflation. The findings are not consistent with the Fama's Proxy Effect hypothesis.