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Inflation drives the rates that steer equity valuations

Inflation drives the rates that steer equity valuations < News < Bet On Markets

The substantially higher-than-expected October US inflation data have aroused fears that the world’s top economy could be on the verge of an upward inflationary spiral.

The data marks a 180¡ turn from as recently as March, when the threat of deflation — a sustained period of falling prices — was the main concern.

The inflation data showed that consumer prices rose 3.2 percent, up from 2.5 percent for the year ending September, mainly as a result of rising prices for oil and base metals such as iron, copper and aluminium.

The core US consumer price index (CPI), which excludes oil and volatile food prices, was unchanged at 2 percent.

Inflation is a primary driver of US interest rates, which not only directly affect macroeconomic growth but influence equity and bond market valuations and performances worldwide.

Correctly identifying US inflation trends is, therefore, of vital importance. The monthly US inflation release attracts a lot of attention but the importance of longer-term trends is sometimes overlooked.

The key question is: Has the US economy, in just eight months, shifted from being in danger of falling into deflation, to being caught in an upward inflationary spiral?

In the US, overall inflation on all major CPI components has declined from the highs of the 1970s and early 1980s, with headline inflation settling at around 2.5 percent since 2000.

However, except for durable goods, which are affected by mainly external factors, none of the other underlying components has shown signs of sustained deflation in recent years.

After scaring analysts and economic policy makers in 2002 by dropping to as low as 1.1 percent, inflation has trickled higher to about 3 percent.

Of importance to investors is that asset classes react differently in different inflationary and interest rate environments.

A look at the correlation between inflation and interest rates and the performance of the three major asset classes — US equities, bonds and cash — over the past 30 years shows that there has been a marginal negative correlation between inflation and equity market performance.

Of more importance is that equity valuations (price:earnings ratios) are highly negatively correlated to interest rates and inflation. During periods of high — and rising — inflation, interest rates tend to rise and price:earnings multiples tend to decline.

The performance of bonds shows no correlation with inflation, but is highly negatively correlated to interest rates, while cash tends to be positively correlated to inflation and rates.

Thus, if the US economy were to fall into a period of deflation, rates would likely decline, resulting in bonds performing strongly and nominal returns on cash continuing to diminish.

The effect on equities would depend on how the economy in general was holding up. If deflation resulted in a substantial slowdown in consumer spending and overall economic activity, equities would be highly unlikely to provide strong returns.

On the other hand, if inflationary pressures escalated in the US, interest rates would likely rise, negatively affecting bond returns, while nominal returns on cash would increase. In this scenario, the sustainability of economic activity within the rising interest rate environment would drive equity returns.

While concerns have diminished over the last six months, it is too soon to say that the spectre of deflation has disappeared, or that the rise in inflation is the beginning of a sustained upward trend.

Implications of this for investors are that they need to be cautious and not take an all-or-nothing stance on allocation.

Diversification remains key considering the uncertainty of US inflationary trends.

By Louis Niemand

Louis Niemand is a market and economic research economist at Investment Solutions.

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