The Relationship between Stock Returns and Inflation: Evidence from Malaysia and Indonesia

Abstract

This study explores the relationship between real stock returns and inflationary trends in the Malaysian the Indonesian economies. It attempts 10 test for the relationship between real stock return and inflation in light of Fisher hypothesis that asserts the independence of real stock return and inflation and Fama’s (1981) proxy effect framework which states thatthe negative real stock retums-inflation is Indirectly explained by a negative real economic actvity-inflation and a positive real stock returns-real ‘economic activity relationships. The findings show that real stock returns are independent of inflationary trends in the Malaysian cconomy in accordance with the Fisher hypothesis, which implies that the Malaysian stock market is a good hedge against inflation. On the other hand, a negative relationship between real stock returns and inflationary trends is found in the case of Indonesia. However. the Fama’s proxy hypothesis was found unable to explain in its entirety the negative relationship between real stock returns and inflation for the Indonesian case. In this context, a positive relationship between real economic activity and inflation and a negative relationship between real stock returns and real cconomic activity were recoeded, which is consistent with the Mundell-Tobin hypothesis.