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It is well known that, at least theoretically, stock prices are expected to rise in an inflationary environment. Now, my question is that does the same go for inflationary expectations; for example if inflation is low at the moment but it is expected to rise sharply in the future, does this expectation cause stock prices to increase at the present time?Assuming inflation is a NEUTRAL phenomenon everything (for example salaries, net income, future cash flows, interest rate and so on) grows in nominal terms.Discussing in dividend discount model (DDM) context for example, in this case, what happen to dividend(D1), dividend growth(g) and investor expected return(k), which their interaction determine stock price?

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  • $\begingroup$ This doesn't answer your question, but, in the Black-Scholes-Merton formula, "inflation" is accounted for by considering the risk-free interest rate. You might try googling "effects of interest rate changes on stock prices" or something like that. $\endgroup$ – barrycarter Aug 29 '18 at 15:51
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Provided that it is always difficult to provide a unique answer to that problem in the stock market (it would be easier to answer it in the bond market instead, at least in my opinion), the simplest way you can look at it is that, if inflation expectations go up WITH all other conditions being unchanged, then future cash flows are discounted at a higher nominal rate. In practical terms, very intuitively, you can think that future money will have a lower real value. Simplifying again the whole issue, you could also say that salary inflation (i.e increased salary due to strong job market) leads to lower margins for companies, with all other conditions being equal.

However, I marked WITH in capital letter because you should always try to understand why inflation expectations are going up. Is it because the economy is recovering from a recession, so that real growth is still expected to be strong? Or is it because the economy is overheating and we expect that growth in real terms will be disappointing? What markets do care about is the capacity of companies of producing, among other things, a sustained REAL growth.

Another aspect is to be mentioned in my quick and dirty answer. There are extreme cases where you have a ultra-high inflation and something resembling a busillish market in LOCAL currency terms. I am referring to some rare cases in emerging markets troubled economies. BUT.. if you adjust the exchange rates and you convert that market performance from local currency into a main currency (let’s say USD for exemplification purposes), then you see that in reality the effect of emerging currency depreciation is so strong that it is more than offsetting the performance of the market in local currency, so that market prices are just trying to reflect a small share of the loss in purchasing power of that currency.

So, to simplify to the extreme, the most important question when it comes to inflation vs stock prices is: what is real growth? Is a market growing its earnings in real terms? Or is it just a case where earnings are growing in nominal terms because real growth is low and/or inflation expectations are too high?

I also stress that inflation has different readings based on what components of inflation you are taking into account. For example, there could be cases where inflation expectations are going up just because energy prices are going up inflating the whole figure: in that case the total reading on the number is highly affected and justified by the energy price impact. So my answer is a very general answer to a general question with no intention to make it universal or exhaustive. But my advice is always to ask, why inflation expectations are going up? are the other conditions remaining equal or not? Will the effect of higher inflation be balanced by other factors? How real growth will evolve?

Moreover, within single companies, some of them are more exposed to inflationary pressure, as they are more exposed to the effect of higher nominal rates on their indebted accounts. Or maybe they operate labour-intensive industries where salary inflation may have the potential to erode margins in a significant way.

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  • $\begingroup$ Thank you for your insightful and intuitive answer. I have revised my question to make it clearer. $\endgroup$ – Soroush Kalantari Aug 30 '18 at 11:57
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Ok thanks for editing, now it is a bit more analytical and specific. I will still simplify for obvious reasons of space and time constraints.

Let’s express D as net income * payout where payout is assumed to be constant over time, so g becomes the growth of net income only. Let’s also express k as risk-free + risk premium. Everything is expressed in nominal terms (p.s.: in some cases of high and unstable inflation company valuation is performed in real terms by cleaning up the effect of inflation on g and rf at the same time, but it’s rare).

Let’s focus on the first and simplest effect: the one on discount rate. If inflation goes up, then the nominal risk free (which in practice is proxied by an appropriately chosen bond rate, usually in same currency and usually long term) goes up and, if the risk premium is assumed to stay constant (for simplicity!), then the discount rate goes up. Then the result of DDM goes down. This is a major effect because the DDM is very sensitive to both discount rate and growth (sensitive to k-g) Let’s look at the second effect: the one on growth, which will be more mixed and more subjected to company-specific issues.

Here the analysis becomes more complex because in reality the projection of future net income absorbs a lot of energy and a lot of time, and is performed by projecting the future expected market size where a company operates, multiplying by the expected market share to get a estimate of revenues and then applying expected margins and expected interest payments and taxes to get up to the net income (and EPS estimate). So from here you understand that you have to consider two main things, as briefly anticipated in my previous answer:

  1. how inflation will act on the company’s revenues, which is a generally low impact especially in certain sectors where inflation indexation of good prices is lower.
  2. how inflation will pressure Ebitda margins, due for example to cost of labour, and other margins (for example net margins due to interest payments depending on debt intensity and debt composition: fixed/floating rates..). Here we have a likely negative effect.

Of course this analysis is very company specific. But you can easily understand that benefits of inflation can be little things compared to the cons of inflation. Especially because, if we assume that the effect of revenues and margins offset each other (which in my opinion is rather optimistic scenario because on average the pricing power of companies in a competitive scenario is not big), then you are left with the relevant impact at the denominator (k). So we come back to the initial point where I said that, if a company can significantly grow its net income as to offset the impact of inflation on margins and discount rates, then the company can still generate value for shareholders.

To understand it from an intuitive point of view, you could dismiss for a minute the reasoning on discount rates and say “if inflation goes up it mens that with dividend received in the future from the company you will by less things than yesterday. So the hope is that this company can grow net income in real terms” (i.e. can growth net income fast enough to offset the loss in purchasing power due to rising inflation).

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