Stock Prices, Expected Returns, and Inflation

Abstract

This paper examines the effect of expected inflation on stock prices and expected long-run returns. Ex ante estimates of expected long-run returns is derived by incorporating estimates of investor expectations of future corporate cash flows into a variant of the Campbell-Shiller dividend-price ratio model. In this model, the log earnings-price ratio is expressed as a linear function of expected future returns, expected earnings growth rates, and the log of the current dividend-payout ratio. Investor expectations of earnings growth are inferred from equity analysts' earnings forecasts; inflation expectations are drawn from surveys of professional forecasters. I find that the negative relation between equity valuations and expected inflation is the result of two effects: a rise in expected inflation coincides with both (i) lower expected real earnings growth and (ii) higher required real returns. The earnings channel is not merely a reflection of inflation's recession-signalling properties; rather, a substantial portion of the negative valuation effect appears to be the result of a negative relation between expected inflation and projections of longer-term real earnings growth. The effect of expected inflation on required (long-run) real stock returns is also substantial. A one percentage point increase in expected inflation is estimated to raise required real stock returns about one percentage point, which amounts to about a 20 percent decline in stock prices. At the same time, the inflation-related component in expected real stock returns has a higher degree of commonality with the component related to the expected long-term bond yield.