According to Dr Oliver, lower inflation equals higher price-to-earnings, lifting the price of shares.
He said a rise in PEs in response to low inflation, provided it’s not deflation, makes sense for three reasons.
“First, low inflation means lower interest rates, which boosts the value of future profits and dividends, making shares more attractive. Or put simply, lower inflation and interest rates boosts the attractiveness of higher-yielding assets so investors switch into those higher-yielding assets, which pushes up their price relative to their earnings, dividends or rents,” Dr Oliver explained.
“Second, low inflation means reduced economic volatility and uncertainty, and hence investors are prepared to price shares on higher price-to-earnings multiples.
“Finally, low inflation means improved quality of earnings as firms tend to understate depreciation when inflation is high and so overstate actual earnings. So again, investors are prepared to pay more for shares when inflation is low.”
Dr Oliver continued to show that, basically, the same applies in relation to property and other assets in that lower inflation drives higher valuations for them as well.
The downside
While it might sound like a positive for investors seeing the value of their assets increasing, the chief economist warns of two downsides.
First, valuations are no guide to timing markets and none of this precludes a correction in shares.
“Second, just as low interest rates and low bond yields mean low prospective returns from cash and bonds, high PEs — or their inverse of lower-earnings yields — and lower rental yields for property point to more constrained returns from shares and property on a medium-term basis,” Dr Oliver said.
“The bottom line is that while shares may be vulnerable to a correction, the rally in markets does not seem excessive given the low inflation and low interest rate environment.”
