Why 3% Inflation Would Spook Stock Markets

Why 3% Inflation Would Spook Stock Markets
Andrew Rummer

almost 3 years ago1 min

If inflation were to pick up strongly, history suggests the stock market’s current high valuations would become hard to justify, according to a report this week from research firm TS Lombard

As the chart above shows, in times when inflation broke above 3%, the stock market’s cyclically adjusted price-to-earnings ratio (CAPE) – its valuation compared to the past 10 years of company profits – has always been below 22. That implies stocks would need to tumble by 40%. 

Central banks are currently trying to spark modest inflation, without allowing the public’s expectations of future price rises to run wild. 

“A little more inflation would be an unambiguously good thing,” TS Lombard reckons. “It would be a sign of a healthier, less stagnant economy than the one we have lived with for the past decade, especially if it was associated with faster wages and rising incomes for the majority, not just the few.”

However, the “highly unlikely” scenario where central banks lose control of inflation expectations, “would have devastating consequences for asset values.” 

All of which helps explain why investors are watching inflation data like a hawk at the moment.

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