According to one explanation of the observed negative relation between U.S. stock returns and inflation, a drop in stock prices signals a drop in economic activity, which leads to a reduction in government revenues, an increase in the budget deficit and an increase in the expected inflation rate. The latter may or may not be accompanied by an increase in real interest rates, depending upon whether or not the government borrows to finance the budget deficit.
Evidence from nine major world stock markets seems to support this theory. Stock returns exhibit a strong negative correlation with changes in expected inflation (as proxied by the short-term interest rate), a much weaker correlation with the level of inflation. There also appears to be a significant, although small, real rate effect, especially in those countries such as Japan, Germany and Switzerland that finance an unexpected deficit by borrowing.
Other, internationally oriented monetary variables appear to have little influence on equity returns, despite increased international investing and the increase in exchange rate volatility since the advent of flexible rates. Changes in real exchange rates and in real interest rate differentials are only weakly correlated with stock returns, and their influence is dwarfed by the effects of domestic interest rate changes.