Should Australian investors worry about inflation?

Should Australian investors worry about inflation?

26 January 2022
by Daniel Leveau, VP Investor Solutions

Australian inflation peaked at almost 4% in 2021. After a decade of remaining at or below the RBA’s 2-3% target range, is the recent spike transitory or will higher inflation become the new normal?

In this blog post we analyse how various inflation levels over the last 50 years affected equity risk premia and valuation multiples of the Australian stock market.


Equity risk premia

Historically, the Australian stock market has achieved its greatest risk premia with inflation levels of 2-3%. Higher rates of inflation have typically resulted in lower equity risk premia. This is in line with the general notion that investors prefer a moderate and stable inflation rate.


Average equity risk premium conditional on inflation level

risk premium

The X-axis reports Australian CPI (year-on-year change) by quintiles. The Y-axis shows the average return of the Australian stock market in excess of the average annualised return of Australian 3-month treasury note. Time period 1970-2021, returns in AUD.
Sources: SigTech analysis, Australian Bureau of Statistics, FRED, MSCI, Bloomberg


Valuation multiples

The main driver of stock market returns long-term are companies’ underlying earnings. However, short- to medium-term, the expansion and contraction of valuation multiples can have significant impact and might result in quick price corrections. The sell-off in the technology sector that started towards the end of 2021, highlights how significant and fast these corrections can be.

Analysing historical performance over the last 50 years shows, the higher inflation, the lower the valuation multiples at which investors are prepared to invest, and vice versa.


Average PE ratio conditional on inflation level

inflation level

The X-axis reports Australian CPI (year-on-year change) by quintiles. The Y-axis shows the average PE ratio of the Australian stock market. Time period 1970-2021.
Sources: SigTech analysis, Australian Bureau of Statistics, FRED, MSCI, Bloomberg


The negative correlation between inflation and valuation multiples is typically explained by (i) increased uncertainty about a company’s ability to pass on rising inflation, and (ii) higher inflation generally resulting in rising interest rates, making stocks less attractive compared to bonds.


Inflation - a key variable

As inflation increased in 2021, uncertainty about the longer term level at which it will stabilise abounds. At the same time, the Australian stock market is trading at valuation multiples markedly above the long-term average. If history were to repeat itself, higher long term inflation suggests that valuation ratios of the Australian stock market are likely to decrease and negatively impact share prices.

Accurately modelling inflation data is complex and derived from multiple macroeconomic variables. Investors need to build complex research models and processes to be able to create realistic inflation forecasts.

To successfully navigate the impact of rising inflation on the Australian stock market, investors have to secure access to usable, timely and high quality inflationary data as well as sophisticated systematic investment tools.

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Disclaimer

This document is not, and should not be construed as financial advice or an invitation to purchase financial products. It is provided for information purposes only and is subject to the terms and conditions of our disclaimer which can be accessed at: https://www.sigtech.com/legal/general-disclaimer