Duncan Lawrie Online ▼

Posted on: 12 June 2015

Last year, we became cautious about the future performance of equities. This was partly based on the high valuation of company shares, which is now above the levels seen before the 2008 crash.

Although stock market history shows that shares can remain highly valued for long periods of time and continue to provide good returns for investors, it makes them very vulnerable to significant setbacks. A rapid rise in inflation is a big risk for the market, yet currently very few investors seem to be concerned about it.

To some extent, all asset classes have been inflated by the quantitative easing (QE) policies employed by central banks. With cash rates at virtually nothing, this has let loose a desperate hunt for yield as the money sloshing about the financial system has sought a home where the investor can earn a positive real return above inflation. This money has found its way into most asset classes, including company shares, bond markets, centralLondonproperty, fine art and many others, all of which could be considered overvalued to some degree.

However, the high valuation of equities can be justified by low inflation and low interest rates. Low and stable inflation means that investors will place a higher value on future corporate cash flows, because it is easier for them to predict. Company shares are valued by discounting these future cash flows using an appropriate discount rate[1] and lower discount rates mean a higher value for those shares today. So as long as inflation and interest rates remain low and stable, equities can continue to be expensive and still generate reasonable returns.

This last point leads us to the heart of the matter: inflation. It has been argued by many that company shares can protect investors against higher inflation because companies with some degree of pricing power can pass on rising prices to consumers, thereby protecting margins and company earnings. However, as John Hussman[2], the famous hedge fund manager has observed, stocks can benefit when inflation is widely anticipated, but they are a poor inflation hedge when inflation is rising rapidly.

It is the rate of change in inflation, even from a low base, when combined with an overvalued market that leads to poor outcomes for equity investors. The last market peak in 2007 provides good evidence for this. In August of that year, US CPI was running at a healthy 1.9%, but by November 2007 it had hit 4.3% as oil prices began to rise from around $70 a barrel to $140 a year later. The US stock market faltered over the summer months and finally peaked in October.

We are therefore watching inflation very closely, not least because markets are not prepared for its return. Investors are still hooked on QE and positioned accordingly. A sudden pick-up in inflation could force a rapid reappraisal and a de-rating of equities. So we are happy to have reduced exposure, even if the benign environment of low inflation and interest rates stays around for a while.

To read more news from The Commentary June 2015 edition please click here

[1]The discount rate in discounted cash flow (DCF) analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate.



All data has been compiled by Duncan Lawrie from sources believed to be reliable. Full details of sources are available on request.

The comments and figures in this document are generally applicable but you should always take specific advice  tosuit your individual circumstances before taking any action. Errors and omissions excepted.

The value of investments and income generated may fall as well as rise, and investors may not get back the amount invested. Past performance is not a reliable indicator of future results.