Effects of Inflation on Stock Market Returns
by Glenn Busch on June 10, 2011
The media’s debate on inflation and deflation has never been stronger. Yet the pundits do not explain why high inflation or deflation is bad for equity markets. Cresmont Research has a chart that succinctly answers these questions.
Expanding and contracting P/E multiples are one of the key drivers to stock market returns. Inflationary and deflationary environments are the cause behind multiple expansions and contractions.
High inflation lowers the overall market multiple applied to the stock market. Higher inflation leads to higher interest rates and higher rates increase the required rate of return on stocks. Government bonds, a less riskier asset, yield more in a rising rate environment. Equity investors require a rate of return much higher than the “safe” government bonds and in order to achieve this higher rate of return, stock prices need to come down. The P/E multiple contracts until it reaches the level where equity investors have the potential to be rewarded for the extra risk they are taking.
Deflation is also troublesome for equity markets. Deflation does lead to lower overall interest rates which is a benefit to equity prices. However, corporate earnings and dividends decline during a deflationary environment like they did in the 2008 financial crisis. Stocks values are based on the future stream of earnings and dividends discounted back to today. A deflationary environment lowers this future dividends and earnings stream. Why would an investor pay a higher price for a stock if it will return lower earnings and dividends? For equities to maintain the required rate of return in a deflationary environment, valuations will need to contract and P/E multiples will contract.
A low and stable inflationary environment is ideal for equity markets. Interest rates remain low and there is less fear of rising interest rates. P/E multiples expand as investors seek marginal returns higher than bonds. Above average equity multiples are easily supported like those we saw in the late 1990s and the years before the 2008 financial crisis. The problem in a low and stable inflationary environment is that it rarely stays here for very long. This is the environment we find ourselves in today.
Core inflation as measured by the CPI remains low and it is fairly stable. However, the outlook on inflation does not look stable. A monetary approach that is too accommodative can spark high inflation as soon as the recovery becomes self-sustaining. A monetary policy that is not accommodative enough or tightens too early may send the economy back into deflation.
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Effects of Inflation on Stock Market Returns
by Glenn Busch on June 10, 2011
The media’s debate on inflation and deflation has never been stronger. Yet the pundits do not explain why high inflation or deflation is bad for equity markets. Cresmont Research has a chart that succinctly answers these questions.
Expanding and contracting P/E multiples are one of the key drivers to stock market returns. Inflationary and deflationary environments are the cause behind multiple expansions and contractions.
High inflation lowers the overall market multiple applied to the stock market. Higher inflation leads to higher interest rates and higher rates increase the required rate of return on stocks. Government bonds, a less riskier asset, yield more in a rising rate environment. Equity investors require a rate of return much higher than the “safe” government bonds and in order to achieve this higher rate of return, stock prices need to come down. The P/E multiple contracts until it reaches the level where equity investors have the potential to be rewarded for the extra risk they are taking.
Deflation is also troublesome for equity markets. Deflation does lead to lower overall interest rates which is a benefit to equity prices. However, corporate earnings and dividends decline during a deflationary environment like they did in the 2008 financial crisis. Stocks values are based on the future stream of earnings and dividends discounted back to today. A deflationary environment lowers this future dividends and earnings stream. Why would an investor pay a higher price for a stock if it will return lower earnings and dividends? For equities to maintain the required rate of return in a deflationary environment, valuations will need to contract and P/E multiples will contract.
A low and stable inflationary environment is ideal for equity markets. Interest rates remain low and there is less fear of rising interest rates. P/E multiples expand as investors seek marginal returns higher than bonds. Above average equity multiples are easily supported like those we saw in the late 1990s and the years before the 2008 financial crisis. The problem in a low and stable inflationary environment is that it rarely stays here for very long. This is the environment we find ourselves in today.
Core inflation as measured by the CPI remains low and it is fairly stable. However, the outlook on inflation does not look stable. A monetary approach that is too accommodative can spark high inflation as soon as the recovery becomes self-sustaining. A monetary policy that is not accommodative enough or tightens too early may send the economy back into deflation.
Related posts: