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Economic Trilogy: Inflation, Interest Rates and Equity Values

Economic Trilogy
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Author: Balkrushna Vaghasia

Co-Author: Khushi Doshi

Glad to see you back, readers!

Equity returns and inflation: What's the relationship between them? A positive connection would seem to be a reasonable assumption. But are things truly so simple to understand? Keep in mind Albert Einstein's famous quote: "Everything should be made as simple as possible, but no simpler."

When you look at the average price levels of today with those of 20 years back, you will notice a many-fold rise. Similarly, the equity index level, for example, BSE Sensex, has risen manyfold during the same 20 years period. The following chart presents the movement of BSE Sensex and Consumer Price Index from 2001 to 2020.

So you can notice a positive correlation between inflation and equity values during the 20 year period. If two things are rising during a period, does it mean a rise in one causing the rise of another? At least not here.

Inflation does not automatically increase equity values. In the long run, expansion in equity values stems from an actual increase in profits and expansion in the price-earning (PE) ratio awarded by market participants. Profits grow primarily because of an increase in sales and/or improvement in efficiency. PE ratio essentially incorporates the expectation of equity market participants at any point in time about future profits.

It is the determination of the PE ratio where inflation plays a vital role. One way to define the PE ratio is Price/Earnings. However, you can look at the PE ratio in the following manner too.

We all know that the value of one rupee today is worth more than one rupee next year or a year after that. So to arrive at the reasonable current value of future profits, you need a discount rate. For the sake of simplicity, let’s assume that it is known that the profit per share of a company for the next 5 years is Rs. 100. And the current price is Rs. 400. Now if you discount the profit per share of Rs. 100 of each year to the present day at 8%, you have a price. So the price and eventually the PE is composed of future profits expectations and the discount rate. You arrive at a higher PE because of higher future profits or lower discount rate or both. The higher the present value of expected profits, the higher the PE ratio.

Some use the cost of capital as defined in the Capital Asset Pricing Model (CAPM) while others use treasury bond rates as a discount rate. Computation of cost of capital requires the risk-free rate which is a treasury bond rate. Warren Buffett, one of the greatest investors of all time, uses the opportunity cost of investing in equities which is the return that he will forgo from investment in other instruments including treasury bonds. The Treasury bond interest rate in itself is dependent on the repo rate of the central bank. All these rates are somehow dependent on the interest rate set by the central bank.

Long story short, the discount rate is largely dependent on the interest rate which is determined by central banks. So, if you want to understand how equity values and inflation correlate with each other, you need to bring interest rates into the picture. Why are interest rates given such importance? Basically, interest rates to equity values are what gravity is to physics. Interest rates enhance or diminish the attractiveness of all asset classes. Interest rates affect the returns of all asset classes including equities in one way or another.

Now that we have understood the importance of interest rates, it is crucial to understand how interest rates and inflation are intertwined. We all understand that economic output and profits oscillate between two ends, boom, and bust, of the pendulum.

If the economy is running red hot and inflation spikes, central banks increase interest rates, discouraging the flow of money for capital expenditure and encouraging the public to save more. Reduction in capital expenditure slows down the employment growth and per capita income growth. Also, higher rates on fixed deposits and other similar products lead to savings by the public in general. All these factors contribute to a reduction in the consumption of various goods and services directly or indirectly. As a result, demand for these goods and services eases and ultimately cools down the upward pressure on prices. As inflation gets under control, the central bank starts reducing interest rates up to a limit where the economy grows at a reasonable pace with a moderate level of inflation.

When there is a risk of economic recession, central banks reduce interest rates to revive and stimulate the economy. Since money can be borrowed at cheap rates, institutions, corporates, and individuals get encouraged to make capital investments, leading to higher employment and expansion of per capita income. These higher income levels boost consumption by people in general. As a result, the expectation, and likelihood of future corporate profit go up. Also, the public is disincentivized to save money because of the low available return on savings. As a result, they buy risk assets. Further, during a low-interest environment, economic actors borrow cheap funds to buy various assets ranging from real assets to financial assets including equities. Caused by various factors, the high demand for equity assets drives the prices up.

To summarise, we can say that interest rates have a negative correlation with inflation. Likewise, equity values are negatively correlated with interest rates. Accordingly, it appears that there is a positive correlation between inflation and equity values if you purely look with the statistical lens. But that correlation is weak. Why? When you look beneath, you will see that the cycle of economic boom and bust keeps happening, with high price levels during the boom and low price levels or no price rise for a long period after the bust. Central banks respond to inflation and deflation by making adjustments in interest rates which in turn have a meaningful effect on equity values. In the short period when inflation and economic growth is at or near the record high or rock bottom, inflation does have a significant impact on equity values but in the long run it is an expansion of profits because of expansion in sales and efficiency lifts the equity values.

Is it better to achieve short-term profits by misinterpreting things, or to gain long-term returns by knowing how things work? I know what you chose. Now, if that is really the choice, then focusing on the profits of the corporations before investing is the right method to opt.

Safe Investing!

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