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The latest US inflation data surprised market participants as it came in as 8.3 per cent YoY against consensus expectations of 8.1 per cent. Released on Tuesday, the overall inflation for August was barely impacted by the softer energy prices, making it an even bigger negative surprise.
As the inflation was driven by a rise in food and housing prices, the investor focus now turns to the US Federal Bank meeting scheduled on September 21, which is likely to increase the interest rate by 75-100 basis points.
Why should Indian investors worry about inflation in far away US, when according to many experts, India has been and will remain a domestic driven economy?
Equity Risk Premium
The answer to this lies in the three-letter acronym ERP—Equity Risk Premium. Equity investors, Indian or US, will have to consider the equity risk premiums and the impact on valuation and hence on stock prices.
When the risk-free rate increases (with government bonds as proxies), the premium attached to the equity asset class (equity risk premiums) will increase.
According to capital asset pricing model, equities, proportionate to risk, will face a higher discount rate pushing the net present value of equity lower. This implies a lower target price or a lower valuation multiple. Besides, investors have a risk-free asset, either US Treasuries or Indian government bonds, priced to yield 3.8 per cent or 6.68 per cent in respective markets for a 2-year bond. The higher risk-free returns offer a competitive investment option to equities.
Equity risk in Indian or US stocks will be increasingly hard to justify, especially when one considers the multitude of additional risks to equities—business risk, operational risk, market risk and interest risk, to name a few.
The low yield in developed market bonds was the primary reason for the attractiveness in international equity asset class post-2008 crisis, which is no longer a viable reason backing investor behaviour.
With inflation still hot, relief not in sight and softening by central banks (Indian or US), not in the audible range, the lure of risk-free returns to investors will continue to get stronger. This will be at the cost of demand for risky assets starting from equities.
Simply put, the same company with the exact earnings growth expectations will get a lower valuation today versus last month or last year due to the higher equity risk premium. While institutional investors will be building sophisticated valuation models and factoring for this, retail investors must also take cognisance of this.
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