Hi, I am a bit confused on what the factors are that can influence the expected return on equity investments. While the notes state that equity is indifferent to interest rates and inflation: "Equity markets should be reasonably indifferent towards high nominal interest rates and high inflation. If the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors." It also references that the "expectations of real interest rates and inflation" will influence the level of the equity market. Is the difference due to the investors expectations of future inflation/interest rates. Therefore, if an investor expects inflation to be high, the demand for equity investment will increase (to hedge inflation), hence demand/price increases. (what impact, if any does this have on the return?) Also, if an investor already hold the asset, are they indifferent to changes in inflation as they are protected? Or have i confused the return and level of equity investments? if so, what is the "level" of the equity market? Thanks!
Hi o.menary11 A few points to hopefully make things clearer for you. The 'level' of the equity market can be thought of as the average equity price in the market. The level/price of equities is inversely related to the return on equities - as returns increase, prices fall and the other way around. The simplified discounted dividend formula can be used to understand how the value/price of an equity would be expected to move given changes in expectations for interest rates and inflation. This formula is d / (i-g) where 'd' is the dividend in a year's time, 'i' is the expected future interest rate, and 'g' is the expected dividend growth. (Of course there are simplifying assumptions that we are making in using this formula but we can still explain price movements more generally using it). 'i' and 'g' include expectations of future inflation, which cancel out so it's the difference between real interest rates and real dividend growth that impacts on equity prices - inversely as these are on the bottom of the formula given. I agree with what you're saying about expectations. If expectations of real interest rates fall, give there's an inverse relationship between real interest rates and equity values - investors will place a higher value on equities and will be more likely to purchase them pushing up the price. If inflation is expected to increase in future then investors (who generally have real liabilities to match) are likely to place a higher value on the inflation protection afforded by equities (all else being equal) and, again, demand would increase pushing up price. If an investor has perfectly matched their liabilities by nature (ie inflation linked or not inflation linked), they should theoretically not be concerned with inflation movements as you say. Because equities are real investments, the same increase in nominal interest rates and inflation should have no impact (all else being equal) on equity markets as real interest rates would be unchanged. Hopefully this helps.
Hi James, thanks for your response, just one question on your final point, "(Because equities are real investments, the same increase in nominal interest rates and inflation should have no impact (all else being equal) on equity markets as real interest rates would be unchanged". Could you please clarify what you mean by "no impact on equity markets"? do you mean the price/level of equites is not impacted? Thanks for your help!
