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Inflation and its impact on securities valuation-value increase or decrease?

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Inflation and its impact on securities valuation

Inflation is the general rise in price level observed over a given period. Inflation should always be classified into Expected inflation and Actual inflation. Expected inflation is the consensus estimation of future inflation. It is incorporated in financial assets’ valuation. Actual inflation is the number observed in a given period. The difference between expected and actual inflation is called Unexpected inflation. Unexpected inflation is the number that causes a change in financial assets’ valuation, as we will see going ahead in this post.

The valuation of financial assets depends on two critical factors – Cashflows and Discount rates. Cashflows represent the economic benefits derived from the asset, and the Discount rate is the required rate of return that incorporates the risk involved in such assets. Based on this framework of Cashflows and Discount rates, let’s discuss how Inflation affects each of these two factors and, ultimately, the final Valuation.

The Discount rates

Discount rates are composed of three components– Real risk-free rate, Inflation premium, and Risk premium.

  • Inflation Premium: Inflation premium is the excess return over a risk-free rate for future expected inflation. It tells us how much investors expect inflation to be over the maturity of the underlying asset (or investment horizon). If actual inflation comes out to be higher than expected, then expectations for future inflation rise, which causes the Inflation premium to increase. Thus, Discount rates go up.
  • Risk premium: Higher inflation levels are often associated with more volatile inflation levels, giving rise to what is called an Inflation risk premium. Riskier companies get more affected by the increased risk premiums as these companies have greater exposure to risk measures.

So, unexpected inflation causes discount rates to rise as both the Inflation premium and Risk premium go up.

 

The Cashflows

Even when actual inflation comes higher than expected, Cashflows from bonds remain fixed as coupons are pre-decided and they are not changing.

With equity stocks, the impact of inflation on cashflows is more complicated. Companies with high pricing power are able to pass prices through to their customers, which allows their revenues to grow at least at the rate of inflation. And companies with large gross margins and inputs, which are in greater control and less exposed to macroeconomic factors, are able to maintain their operating margins; with this if duration of investments made by companies is short and they are more flexible in nature, then such companies are able to keep their earnings and cashflows growth intact even during rising inflation periods.

On the other hand, companies with lesser pricing power and higher input costs suffer from inflation; the worst part is that these companies constitute a significant chunk of the market.

The Valuation

Fixed cashflows and increased discount rates cause the valuation of bonds to fall. With stocks, most companies will see their cashflows falling, and with a higher cost of equity, valuations will shrink. But well-established companies with positive free cashflows, increased pricing power, fewer input costs, and short duration & flexible reinvestment needs, and relatively less exposure to rising risk premiums may outperform broader equity markets; however, there are only a few companies that exist with all these features.

Investor Considerations

Empirical evidence suggests that Equities and Bonds have performed pathetically during high inflationary environments. Few companies (as mentioned above, with increased pricing power and less exposure to risk measures) might perform better than the rest of the markets. Income-producing real estate properties and commodities may also provide a good inflation hedge. Cryptos and NFTs can be presented as exciting choices, but the volatility observed in these makes investors doubt whether they will be able to maintain their value during bad times.

Conclusion

Rising and volatile inflation is not a healthy sign for financial markets and the overall economy. However, some real assets may survive during a high inflationary environment and provide better returns to investors. However, this is not the case with most financial assets. Inflation affects financial securities’ valuations negatively. So, policymakers in an economy need to keep inflation in check. How effective are central bankers in controlling inflation? Share your thoughts, please.

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