The Impact of Expected and Unexpected Inflation on
Local Currency and U.S. Dollar Returns from Foreign Equities

Abstract

This article examines the impact of inflation on stock returns. We find that inflation that is expected is significantly positively related to local currency equity market returns while inflation that is unexpected is significantly negatively related to local currency equity market returns. In addition, our estimates show that unexpected increases in inflation have a negative impact on equity returns during the year that inflation increases unexpectedly, but a positive impact on subsequent years’ equity returns. The rationale is that the current years’ unexpected inflation becomes subsequent years’ expected inflation. With respect to the impact of inflation on a country’s FX rate relative to the U.S.dollar, we find that inflation that is expected is significantly negatively related to the local currency’s performance versus the U.S. dollar, while inflation that is unexpected is significantly positively related to the local currency’s performance versus the U.S. dollar. In the aggregate, after combining local currency equity market returns and FX returns, we find that countries with higher expected inflation tend to experience higher equity returns in U.S.dollar terms and that countries with higher unexpected inflation tend to experience lower equity returns in U.S.dollar terms. The results imply that U.S. investors should seek to invest in foreign countries with either high but stable inflation or with declining inflation.