Impact of inflation: Aswath Damodaran decodes the impact of runaway inflation on the economy and markets

Stock markets are struggling to find their footing as the dark clouds of higher inflation and interest rates, along with slower economic growth, have come to stalk economies around the world. Valuation guru Aswath Damodaran says the good news is that the culprit behind this volatility is easy to spot, which is inflation, but the bad news is that inflation remains the most unpredictable of all macro factors to factor in. in stock prices and value.

The history of inflation
According to Damodaran, since 2020 inflation has become a key area of ​​attention, although experts barely mentioned it until 2020 despite being a

investment and valuation component.

“We have had a long run of low and stable inflation, and that is especially true since the 2008 crisis. In fact, the average inflation rate in the 2011-20 decade was the lowest in seven decades,” Damodaran wrote in your blog. “Reflections on the markets”.

Damodaran says that the last time economies witnessed high inflation was in the 1970s, when investors had no reason to believe they were headed for a decade of higher inflation, and initial signs of price increases were attributed to factors temporary, with OPEC being a suitable target.

“In fact, expected inflation was lower than actual inflation for much of the decade, and the damage done to financial asset returns in that decade was due both to actual inflation being higher than expected inflation, period after period, like higher inflation,” he said.

Damodaran says that there is a misconception that the Federal Reserve is a very powerful entity that sets rates, determines economic growth and keeps inflation in check, which is actually a myth as it gives license to policy makers and investors to behave irrationally, expecting a safety net to protect them. them from their mistakes.

Economic impact
Damodaran says that with high inflation returning, concerns about what might happen to the economy to bring inflation back under control have also increased. Almost all economic forecasting agencies have increased their assessed probability of a recession.

Damodaran says that while he avoids making any predictive statements about future economic growth, it can be stated categorically that there is a greater chance of an economic slowdown now than just a few weeks ago.

What awaits your investments
Damodaran says that the question of whether to buy, sell or hold investments in these uncertain times will depend on macro assessments of the following:

Steady State Interest Rate: Damodaran says the 10-year bond rate has doubled this year and there are three possibilities for the future.

1. Most of the movement in rates is over and Treasury rates now reflect updated inflation expectations.

2. Just like in the 1970s, investors will have to catch up with inflation, and rates will continue to rise, until expectations about inflation become more realistic.

3. Inflation is transitory and will return to the lows seen in the last decade, or the economy will enter a recession and act as a natural brake on inflation and interest rates.

Equity risk premium path: Damodaran says that the 5.24% equity risk premium, estimated as of early May 2022, is at the high end of historical equity risk premiums, but there have been higher premiums, either in crises in late 2008, the first quarter of 2020, or when inflation has been high in the late 1970s.

“I think what happens to equity risk premiums for the rest of the year will very much depend on the inflation numbers, with high and volatile inflation continuing to push the premium higher, and stable and declining inflation It has the opposite effect,” he says.

Earnings Estimates: Damodaran says the strength of the economy has gone a long way in boosting companies’ actual and expected earnings over the past two years, and these higher earnings have translated into more cash returned in dividends and buybacks.

He says analysts’ earnings estimates for S&P 500 companies, as of early May 2022, reflect that strength and it appears there was no downward adjustment for a recession possibility.

“That may reflect the fact that equity analysts are not among those expecting a recession (or expecting only a very mild one, with little impact on earnings) or the possibility that there is a lag in the process between weakening the economy and analysts adjusting expected earnings,” he says.

Damodaran says that to see how these three forces play out, one can consider a status quo scenario, assuming the Treasury rate (3%) is the steady state, earnings estimates will be largely delivered and that the equity risk premium will stabilize around the current one. levels

Taking this data into account, it is seen that the intrinsic value of the S&P 500 index is almost equal to the real value, since it reflects the consensus opinion on rates, earnings and risk premiums.

However, there may be a big difference from the consensus on the three entries. Let’s look at the different scenarios-

Much ado About Nothing- Damodaran says that in this scenario, inflation may prove transitory, fears of economic collapse may be exaggerated and the equity risk premium may return to historical norms, and the market may appear undervalued.

The seventies show-He says that in this scenario, inflation may continue to rise, even as the economy enters a recession and risk premiums rise, leading to a further correction of close to 50% in the market.

The Volcker Replay According to Damodaran, in this scenario, Jerome Powell could crack down on inflation, but he would do so by pushing the company into a deep recession, making himself extremely unpopular.

Live and let live (with inflation)- He says that in this scenario, investors and consumers will accept a world with higher inflation, with its costs and consequences, as the price to pay to keep the economy going.

Damodaran says that if history is any guide, bringing inflation under control will take time and create significant pain.

“It is the lesson that the United States learned in the 1970s, and that other countries have learned or have chosen not to learn from their own encounters with inflation,” he says.

According to Damodaran, when inflation became visible in early 2021, the Fed should have taken it seriously and responded quickly, even if there was a chance it was transitory. But instead, the Fed and the administration chose a different path by not only ignoring the danger, but also making decisions that only made the danger worse.

Damodaran feels that the Fed is now between a rock and a hard place (more inflation) and a tough place (a recession), and the truth is that everyone will suffer and feel the pain as a result.

(Disclaimer: This article is based on Aswath Damodaran’s “Musings on Markets” blog)

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