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Low, Stable Inflation to Boost Stock Prices

Low, Stable Inflation to Boost Stock PricesLow, Stable Inflation to Boost Stock Prices

While expectations are running high that an end to economic sanctions against Iran and a return of foreign investment will boost stock valuations, economists increasingly point out that another factor might be even more crucial: low and stable inflation.

A recent survey by the economic daily Donya-e-Eqtesad shows that the fall in stock prices over the past two years can be ascribed to high, although falling, inflation and sticky interest rates.

The daily reviews the TSE-reported price-to-earnings ratio, or the price investors are willing to pay for stock over the earnings-per-share, to show that low and stable inflation leads to higher stock valuations.

Theoretically, rising inflation means that shareholders want a higher rate of return to maintain their purchasing power, causing the P/E to fall. High inflation also normally leads investors to revise their risk evaluations upwards–another factor that puts downward pressure on the P/E.

On the other hand, low and stable inflation, especially in combination with low interest rates, provokes investor capital to flood into stocks as confidence rises about constant returns and economic expansion. In an extreme example, US quantitative easing kindled higher P/E ratios at home and globally in response to state-backed share price growth.

In the case of Iran, this neat model does not hold completely. When the EU and the US tightened sanctions in 2012, inflation exploded but P/E ratios did not fall. In fact, TSE experienced an exceptionally long and sharp rally as investors put their trust in the government’s pro-business expansionary policies.

Simultaneously, company earnings were boosted by a depreciating currency and rapidly plunging labor costs. What was, indeed, going on was a large transfer of assets, not only from the state to the private sector, but also from small investors to large institutional brokers and firms.

The slump started in early 2014 when the new government pushed a new set of contractionary policies in order to reduce inflation.

It seems that this state of continued high, albeit steadily falling inflation in combination with high interest rates affected P/E ratios much more than the previous scenario. P/E ratios averaged 7 when inflation reached 35% in 2013, but have since fallen to around 5.5 amid continued worries about the financial health of many TSE-listed firms.

These exceptional times have transcended economic models, but that does not imply that common wisdom cannot be used to predict the future of the Iranian stock market. The survey shows that inflation rates of around 13%-relatively low for Iran—have over the past 10 years been linked to P/E ratios of between 7 and 9.

It is likely that the P/E will move to this level once again when inflation stabilizes. In a context of stable inflation, the government will reform its current contractionary program, reestablishing financial lifelines to firms. Additionally, the removal of sanctions will lower transaction costs and risks, and boost exports of key oil- and gas-related industries. With these in mind, stock valuations look set to increase again in the near future.

Financialtribune.com