The impact of inflation and interest rates on companies’ price to earnings ratios

Currently surging US inflation has triggered a dramatic move in interest rate expectations, which in turn have inspired equity investors to reassess the risk they are willing to adopt. In the space of seven months, US short term interest rate expectations have moved materially.

Back in July last year, the US Federal Funds rate was expected to be 0.3 per cent by the end of calendar 2022. Today, the rate at that time is expected to be 1.25 per cent.  And the old 0.3 per cent target is now expected to be exceeded in a matter of weeks.

The shift in sentiment to higher rates and sooner has been dramatic.  And the repercussions for equity investors have been impossible to ignore. The simple fact is, for the last four decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined. In every one of the seven phases US 2-Year Treasury yields rose between 1980 and today, the US S&P500 12-month forward PE Ratio declined.

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