Valuation is closely tied to inflation, but it is not a linear relationship. High valuation is associated with lower inflation levels. There are two key reasons for this link: an earnings effect and a discount rate effect. Lower expected inflation is associated with lower yields or discount rates which will boost earnings. Lower inflation is associated with an improvement in real earnings growth. Additionally, lower inflation is also associated with lower price volatility so there is more certainty about potential revenue, investment decisions, and pricing decisions.
The inflation valuation trade-off exists even though the classic discount rate model suggests that inflation is neutral. Given the current location on the curve, equities are overvalued and will have to come down even if inflation moves higher or marginally lower. Repricing of inflation expectations leads to repricing of equity values.
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