Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Low rates, inflation help push shares higher

Nicki Bourlioufas  |  01 Feb 2021Text size  Decrease  Increase  |  
Email to Friend

Ongoing low inflation is likely to force even more people out of low- or nil-yielding cash investments and into shares, triggering higher valuations. Already, the very low interest rate environment has pushed US markets to record highs in recent times while Australian shares are trading higher too.

The Consumer Price Index rose 0.9 per cent in the December 2020 quarter, according to data from the Australian Bureau of Statistics. Over the twelve months to the December 2020 quarter the CPI rose just 0.9 per cent with most economists predicting ongoing low inflation in 2021 and well beyond, given sluggish economic activity due to the pandemic.

“The CPI is still being influenced by government taxes and subsidies which have been pushing and pulling on the data,” said Justin Smith, a senior economist with Westpac after the release of the ABS data. “However, outside of dwelling prices we found little to suggest more broad-based inflationary pressures.”

Adam Fleck, director of equity research at Morningstar Australasia, says low inflation supports the overall share market. He says that for every 25-basis-point fall in interest rates, there is potentially a corresponding 8 to 10 per cent rise in the value of shares.

“We get big changes in valuations when interest rates are so low and they can have a big impact,” says Fleck.

“So, with such low levels of inflation, share prices will likely stay higher for longer. When interest rates are this low, people are willing to move into shares as they offer a higher rate of return compared to cash.

“However, you’d expect that when inflation goes up, that would probably have a negative impact on the share market, though some companies will do better than others, especially those with pricing power.”

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

Morningstar analyst Brian Han says for income-seeking investors, low inflation and low interest rates increase the relative appeal of high dividend-yielding stocks such as Telstra (ASX: TLS), especially given their fully-franked status, “although other industry/company specific factors have put on a lid on Telstra’s share price,” says Han.

Valuation impact

According to AMP Capital chief economist Shane Oliver, low inflation means lower interest rates which boosts the value of future company profits and dividends, making shares more attractive.  

“Or, put simply, lower inflation and interest rates boosts the attractiveness of higher yielding assets, so investors switch into those higher yielding assets which pushes up their price relative to their earnings, dividends or rents,” says Oliver.

“So, while [US] share markets may be around record levels and price-to-earnings multiples are relatively high there is some rationale for this given that it’s a low inflation and low interest rate world. And the longer inflation remains down it’s conceivable that the higher PEs may go. How high is impossible to know for sure,” says Oliver.

The chart below shows the long-term relationship between inflation on the horizontal axis and the price-to-earnings (P/E) ratio on the vertical axis. The P/E ratio tends to move higher as inflation falls, although it is less clear once inflation falls into deflation. Australia briefly saw deflation in the June quarter last year—but it was due largely to a fall in childcare costs which was a government decision.

"Excluding volatile items, we just saw low inflation and that remains the case,” says Oliver.

a chart showing US price to earnings and the effect of low inflation

However, over the longer term, higher P/E ratios may limit returns from shares, that is, when share prices are relatively high compared to earnings, subsequent returns tend to be relatively low.  

The inverse relationship exists for Australian shares, says Oliver. A sharp acceleration in inflation would drive sharply higher interest rates and a revaluation downwards in prices for shares and other assets. 

MORE ON THIS TOPIC: While you were quarantining ... 

Morningstar’s Fleck agrees and says for investors buying at higher values, “if you pay a higher price, you should get a lower rate of return as a result.”

Some companies, however, do benefit from higher inflation, particularly those with pricing power, says Johannes Faul, retail analyst with Morningstar.  Supermarkets, in particular, do well when prices are rising unlike some other companies that might be hit by higher costs.

“For supermarkets, during a period of higher inflation, they benefit from rising prices as their earnings typically rise faster than their cost base and their profit margins widen,” says Faul.

That was especially evident during the March and June quarter of 2020 when the demand for food during the early stages of the COVID-19 pandemic lifted.

"Promotions were scaled back when there was a lot of panic buying, especially in the March quarter, which lifted prices at Coles (ASX: COL) and Woolworths (ASX: WOW). Food inflation has come back down, and we even saw prices fall at Woolworths during the September quarter wind food prices, excluding tobacco and fresh produce, fell 0.2 per cent.”

As for the direction of share this year, in line with low inflation, values are expected to move higher, though volatile.

“Shares remain at risk of a short-term correction after having run up so hard recently and 2021 is likely to see a few rough patches along the way (much like we saw in 2010 after the recovery from the GFC),” says Oliver.

“Looking through the inevitable short-term noise, the combination of improving global growth helped by more stimulus, vaccines and low interest rates augurs well for growth assets generally in 2021.”

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

See also Morningstar Guide to International Investing.

is a Morningstar contributor.

This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. 

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend