Inflation and Valuation

[jyl]

The inflation genie periodically arises here. I don’t know if inflation is headed higher or lower, but the Fed is trying to push inflation up and has just raised its target from 2% to something above 2%.

Classically, the theory is that higher inflation led to higher interest rates which lowered valuation multiples. (Whose theory? Well, mine, although I read it somewhere.)

Look at the present value formula V = C / ( r – g ) where V is present value, C is present cashflow, r is interest rate, g is growth rate of future cashflow. Higher interest rate increases r. Higher inflation may or may not increase g. Inflation increases both sales and expenses, how much for each – and thus whether cashflow increases – varies by industry. For the S&P 500 overall, g increases less than r. So r – g increases, and V declines. C is fixed, being today’s cashflow. So V / C declines, and that is your valuation multiple.

The real world is too messy and aberrant to closely fit such a simplistic formula, but I think that helps with thinking about directional changes.

As for why higher inflation leads to higher interest rates, classically if investors expect a future dollar to buy fewer goods, services, and labor on Main St, they demand more of those future dollars on Wall St. This is a link between the real economy and the financial economy.

What happens if you break that classical relationships, and higher inflation does not lead to higher interest rates? Sever real and financial economies by applying some force to hold rates constant regardless of inflation.

Now r is constant but g increases, r – g decreases, V rises, V / C rises, and valuation multiples rise.

Central banks have learned how to push down on rates, by buying bonds (QE). The Fed has the buying power to move any market, even the bond market.

Goverments have always known how to push up on inflation, by spending.

The disconnect between the real economy and the financial economy widens.

[island911]

Wage inflation? Housing inflation? Energy Deflation? ...

it is all fluid.

The Fed infuses new cash to in a multitude of places. The trick is to keep pace with increasing value while encouraging a smart use of resources. - stabilize currency to avoid dollar volatility (either up or down)

[jyl]

The Fed's toolkit is blunt. They can buy $4TR of bills, bonds and paper, and thus suppress borrowing rates throughout the financial markets. They can't control where that $4TR is re-spent or what companies do with those lower borrowing costs. They have no ability to encourage smart use of resources. They can prop up asset prices generally, and enable higher government (and corporate, and consumer) borrowing.

[RWebb]

Originally Posted by jyl

...
The real world is too messy and aberrant to closely fit [] a simplistic formula, ...

never stopped any economist before

[JackDidley]

I have no clue what will happen but I need interest rates to go up. If they go any lower the bank will charge me to have an IRA.

[stevej37]

^^^ 2% seems like a dream today.

[jyl]

Money market funds have been waiving fees to keep yields above nothing. Yields are barely positive now, like 0.01%. This isn’t sustainable.

[island911]

Originally Posted by JackDidley

I have no clue what will happen but I need interest rates to go up. If they go any lower the bank will charge me to have an IRA.

Originally Posted by stevej37

^^^ 2% seems like a dream today.

So if you have an IRA that pays 2% in when gross inflation is at 3% ...

2 steps forward and 3 steps back. .. But at least you can say you made money on it.