CHAPTER ONE
1.1 INTRODUCTION
The stock market is considered as one of the safest destinations for putting one’s money
during the periods of inflation. The market is an important avenue for channeling funds into the
needy areas of the economy (S Mbulawa,2015). These equity markets create a forum for trading
in financial assets, whereby business firms are able to acquire investment funds through the
issuance of shares and thus facilitating them to meet their investment objectives. Stock markets,
as Olweny and Kimani (2011) observed, encourage investors with surplus funds to invest them in
additional financial instruments that better matches their liquidity preferences and risk appetite. In
that respect, better savings mobilizations increase the savings rate, thereby stimulating investments
and subsequently earning investment income to the owners of those funds.
The existence of inflation in an economy affects the performance of stock markets particularly
stock prices which eventually affects stock returns (Kimani and Mutuku 2013). Inflation can be
problematic to investors as they expect low payoffs from stocks, however some investors will be
optimistic about getting higher returns from stocks. Several theorists and other researchers have
suggested that many investors prefer stock investments in times of inflation in order to protect
their wealth (Anari and Kolari,2001). Unlike other real assets, stock investments are characterized
by high liquidity and transparency and generally provide good inflation hedging properties (Bilson
et al, 2001). Many empirical studies have produced various findings on the ability of stocks to
hedge against inflation through analyzing the relationship that exists between stock market returns
and inflation.
It is imperative to analyze the connection between stock market returns and inflation in Zimbabwe
since stocks are expected to provide protection from the effects of inflation. According to the
Fishers (1930) hypothesis, shares can act as a hedge against inflation. He suggested that during the
period of inflation investors will be interested in the real value of their investment and an increase
in the nominal value of shares will be a form of compensation for continuous increases in prices
which helps to maintain the real value of stocks. The study will test the applicability of the Fisher’s
hypothesis and empirically determine the impact of inflation on stock returns in the Zimbabwean
stock market.
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1.2 BACKGROUND TO THE STUDY
Established in 1894 and once ranked second to South Africa in terms of market breadth and depth,
the Zimbabwe Stock Exchange (ZSE) has had its successes and failures owing mainly to the
performance of the political economy (Sibanda & Holden, 2013) . The ZSE has two main indices,
the industrial index and the mining index. The exchange has experienced a drop in the number of
firms listed from 76 in 2010 to 58 in 2015. This decline in the number of listed companies is mainly
due to suspensions and delisting arising mainly from viability issues (Rusvingo, 2014).
In 2008, Zimbabwe experienced unforgettable hyperinflation conditions that decimated the
viability of most of the economic sectors. The hyperinflation conditions caused some unusual
behavior of the stock market whose growth ballooned in nominal terms contrary to economic
fundamentals that grappled under the heavily taxing macroeconomic conditions (Tapfuma,2009).
Fascinated by the phenomenal growth of the Zimbabwe Stock Exchange, many investors tend to
make use of the local bourse in order to protect their assets and achieve a level of real returns
consistent with their investment objectives. Despite the expectations of stock market analysts who
perceived the bourse to crumble together with the economy, it performed extra ordinarily well
during the time of hyperinflation (Njanike 2009). The main reason being the fact that many
investors believed equities would provide a good hedge against inflation.
Conventional wisdom holds that equities should act as an effective hedge against inflation
(Lee,1992) as they represent a claim against real assets whose real returns should not be affected
by inflation (Lee,2010). Traditional assumption also argues that stocks are a claim to real assets
and should offer full hedge against inflation. The foundation of discourse on the relationship
between stock market returns and inflation is the Fisher (1930) hypothesis (Osagie & Emeni,
2015). The Fishers hypothesis presuppose that shares can act as a hedge against inflation during
the period of inflation (Mbulawa, 2015).
Nevertheless, Fama (1981) introduced the proxy hypothesis which contradicts with the Fishers
hypothesis. He suggested that stock market returns and inflation have a negative relationship hence
stocks cannot hedge against inflation. Modigliani and Cohn (1979) also came up with the inflation
illusion hypothesis explaining the negative relationship between stock returns and inflation.
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Despite all the theories being relevant in trying to explain a negative relationship between the
stocks returns and inflation, the Zimbabwe Stock Exchange has proved to go along with the
Fisher’s hypothesis where the inflation rate will be escalating together with the stock returns due
to investors sentiments on how to effectively hedge against inflation. To add on, in times of
inflation investors will be seeking alternative investments in stock markets in order to keep the
purchasing power of their portfolios hence they may invest in equities (chikoko and Samu 2012).
Njanike (2009) also suggested that there has not been any other liquid means to store value since
banks have proved to be vulnerable to the threats posed by inflation hence investors had to make
use of the stock market.
In the view of the wide range of conflicting empirical studies on how inflation in emerging markets
affect the rate of stock returns, one cannot draw conclusions from them with any minimal
acceptable level of confidence. Also, given the fact that the ZSE has been performing
extraordinarily well when analysts had expected the bourse to crumble, one can still question the
capability of stocks as a hedge against inflation. To add on, the numerous literature on inflation
and stock returns in Zimbabwe has not received the attention it deserves. Hence, the study seeks
to empirically determine the impact of inflation on stock returns in the Zimbabwean stock market
and to analyze the effectiveness of equities as a hedge against inflation on the Zimbabwe stock
exchange for a period spanning January 2009 to December 2016.
1.3 PROBLEM STATEMENT:
Since the 19th century economic research has been critical to policy formulation and possible future
planning decisions (M Kamoyo et al,2015). There has been a lack of a clear cut study which
analyses the effectiveness of equities as a hedge against inflation on the Zimbabwe stock exchange.
This has been mainly due to the fact that most researchers were focusing on the impact of inflation
on the Zimbabwe stock exchange in general and none of them examined if equities were a good
hedge against inflation.
Nevertheless, some researchers have empirically studied the relationship that exists between stock
market returns and inflation. The findings were still mixed given that some were sensitive to the
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choice of countries and the time period studied. However, it is difficult to generalize the results
because each market is unique in terms of its own rules, regulations and type of investors
(Mehwish, 2013). Consequently, there is no definitive conclusion regarding the nature of the
relationship between the two variables.
Since there is a shortage of literature in Zimbabwe and there is also lack of consensus within both
the theoretical and empirical framework regarding the nature of the relationship between equity
returns and inflation, it has become a matter of concern to the researcher hence this study will
analyze in detail the nature of the relationship between stock returns and inflation in the context of
the Zimbabwean stock market.
1.4 RESEARCH OBJECTIVES:
The main objective of the study is to ascertain if equities can provide an effective hedge
against inflation on the ZSE. However, this study will entail to fulfilling the following
objectives:
 To structure a regression model that captures the relationship between stock market returns
and inflation using data from the Zimbabwe stock exchange.
 To test for granger causality between stock market returns and inflation
 To test for statistical difference between stock market returns and inflation in Zimbabwe
for the period 2009 to 2016.
1.5 RESEARCH QUESTIONS:
 Can ZSE listed stocks provide an effective inflation hedge to Zimbabwean investors?
 What is the nature of the causal relationship between inflation and stock market returns in
Zimbabwe?
 Has the Zimbabwe stock exchange generated returns in excess of inflation between 2009
and 2016?
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1.6 RESEARCH HYPOTHESIS:
Hypothesis 1
H0: There is a relationship between inflation rate and stock market returns.
H1: There is no relationship between inflation rate and stock market returns.
Hypothesis 2
H0: Inflation rate does not granger cause stock market return
H1: Stock market return does not granger cause inflation rate.
1.7 JUSTIFICATION OF THE STUDY
Many earlier studies on the effectiveness of equities as a hedge against inflation in emerging
markets are based predominantly on evidence from developed countries for instance European
countries, United States of America and East Asian countries (Owusu, 2012). Little attention has
been devoted to African countries, especially those in the Southern African region and in particular
Zimbabwe. Therefore, a need exists for studies that explore the effectiveness of equities in hedging
inflation in Zimbabwe.
This research aims to make a meaningful contribution to the understanding of the relationship that
exists between stock market returns and inflation using data from the Zimbabwe stock exchange.
Evidence from empirical literature in Africa reveals that the causal relationship between stock
market returns and inflation has not received much attention (Ziwengwa et al (2011). This
therefore calls for further research to provide a reflection on the nature of the relationship and the
direction of causality between stock market returns and inflation.
The choice of variables (inflation rate and stock market returns) used in the regression is limited
to the sole determinants of the stock price movement. Stock prices were proxied by the industrial
index from the Zimbabwe Stock Exchange. The index was selected because it is the average returns
for all firms listed on the stock exchange, individual counters were not used because they reflect
firm specific factors rather than market characteristics. Inflation was proxied by the consumer price
index instead of the producer price index because investors as ultimate consumers they make a
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tradeoff between consumption and investment. The study further offered the researcher an
opportunity to develop research skills which would be a good foundation for research at a more
advanced level.
1.8 SCOPE OF THE STUDY
The study focuses precisely on the inflation hedging capability of equities traded on the Zimbabwe
stock exchange and the relationship that exists between inflation and equity returns. In line with
the research objectives, empirical investigations were carried out on the impact of inflation on
stock returns using data from the Zimbabwe stock exchange. This study did not cover all the
variables that affect stock returns and only interest rates, money supply and exchange rates were
used as control variables. The usefulness of the research findings is limited to Zimbabwean
economic dynamics thus they cannot be generalized. Only in a developing economy with capital
market dynamics similar to those in Zimbabwe could these results apply. The researcher further
identifies the causality relationship between stock returns and inflation using the granger causality
test. The study covers a period ranging from January 2009 to December 2016, which is a period
that marked the end of Zimbabwean dollar era with the introduction of a multicurrency system.
1.9 ASSUMPTIONS OF THE STUDY.
Before the study was undertaken, the researcher made the following assumptions:
1. There is a linear relationship between inflation and stock market returns, hence a need for
multiple regression model in order to analyze the relationship between the two variables and
other control variables.
2. Time series data used is non-stationery, hence a need to conduct unit root tests.
3. All secondary data on economic history, behavior and statistical information is accurate and
reliable.
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1.10 LIMITATIONS OF THE STUDY.
The focus of this study was the relationship between inflation and stock market returns at
the Zimbabwe Stock Exchange. Thus, the findings of this study are limited to stock returns of firms
listed at the ZSE and they may not be replicated in other stock exchanges. Additionally, the
findings are limited to Zimbabwe since the effects of inflation are different in various countries.
Further, since finance is in part a behavioral issue, the study has only provided findings applicable
within the context of the historical data. As to whether the findings are applicable after 2016 or
before 2009, the study has not expressly investigated that.
The study assumed that the relationship between stock market returns and market return indicators
is linear. This assumption led to the use of the multivariate linear regression model. There is a
possibility that the relationship is not linear like used in the analysis among all the variables of
market returns and that could be why some of the variables weakly explained the variation in
market returns.
1.12 ORGANIZATION OF THE STUDY
This study is organized as follows:
Chapter One - Introductory Chapter:
This chapter forms the foundation of the entire project. The chapter has presented the research
problem, objectives of the research, significance of the study, various research questions, scope
and justification of the study has also been explained.
Chapter Two - Literature Review:
In order to create a comprehensive understanding of the research, this chapter provided the
theoretical background and empirical evidence of the study.
Chapter Three - Research Methodology:
This chapter will outline the research methodology that was used in the study to obtain all the
results from the study. It also presents an overview of the research design, as well as data collection
and analysis procedures that were used.
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Chapter Four - Data Analysis and Presentation:
The results of all the econometric tests conducted are analyzed in this chapter. Moreover, the
outcome of the tested hypotheses is also demonstrated.
Chapter Five - Research Findings, Conclusions and Recommendations:
This chapter outlines the research findings, the conclusions and policy recommendations that are
derived from the research findings.
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