Low inflation is arguably still the linchpin for economic policy and financial market sentiment in the US. The relationship between inflation and the price-to-earnings ratio has tightened since the launch of QE. However, it remains to be seen if subdued inflation will continue to support equity valuations, in the face of tapering.
There is a long standing relationship between inflation and the price-to-earnings ratio. Stable and moderate inflation tends to lead to a higher price-to-earnings ratio. Since the crisis began, inflation has remained subdued in the US, and we expect this to persist. Over the next twelve months, we expect headline inflation to be volatile but not to move materially in either direction. A strong dollar and a stabilization of energy prices keeps US inflation from rising. Meanwhile, core PCE inflation is likely to hover at just above 1%.
At the zero lower bound, weak â€”yet positiveâ€”inflationary pressure validates a continuation of loose monetary policy, boosting stock market multiples. It is no surprise that the relationship between the PCE deflator and the S&P 500 price-to-earnings ratio has become considerably tighter since the launch of QE. While unemployment receives the most attention these daysâ€”even from central bankersâ€”it is low inflation that arguably constitutes the linchpin of US economic policy and positive financial market sentiment.
It remains to be seen whether continued subdued inflation will continue to support US equity valuations, in the face of tapering. But if history is any guide, the 1994 episode suggests that a combination of strengthening growth and low inflation should support equities despite higher interest rates.
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