And in the stock market, where is the inflation?

Xavier Brun
Director of Master in Finance and Banking
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The great protagonist at the beginning of the year is none other than inflation. It is not surprising, the interannual rate was 5% in the Euro Zone, 6.5% in Spain or 5.3% in Germany. Abnormal levels not seen in the last 15 years. If we add to this that 30% of dollars and 15% of euros have been printed between 2020 and 2021, one reaches the conclusion that interest rates must rise if inflation is not to skyrocket. Even more.

And the effect of a rise in interest rates on the stock market is clear: an increase in banks or raw materials and a drop in technology companies. Behind this there is a compelling theoretical reason. Banks, if they raise interest rates, they earn more money, with which they are worth more. Raw materials, if inflation rises, the raw material will be worth more and as a consequence the companies will earn more. Technological, if interest rates rise, the current value of their high future profits will be lower and therefore their valuation, investors prefer returns in hand than a hundred flying.

30% of dollars and 15% of euros have been printed between 2020 and 2021: interest rates must rise if inflation is not to skyrocket further.

Now let's look at the effect it has had on the markets. If we take the Stoxx 600 index, we see that as of January 25, it was approximately -6% for the year. The sectors that had risen the most were Energy, Banks and Raw materials between 4 and 5%. While the one that had fallen the most was technology with -14%. All on schedule.

Daniel Kahneman, Nobel laureate in economics in 2002, described in his book Thinking fast, thinking slowly that the brain has two thought systems. System one, quick and instinctive thinking, and system two, slow and logical.
This seems to be exactly what has happened to the markets. System one has acted and has resulted in the returns shown above. Now we should wait for system two to enter the scene.

And what does system two tell us? Let's take a technology company that we all know, Microsoft. In the year it has dropped by 12%. Regardless of whether or not it may be cheap, let's analyze the impact that inflation can have on the company's valuation.

The valuation is the result of dividing benefits by interest rates. If inflation rises, interest also rises, causing the denominator of the equation to increase and, as a consequence, the valuation to decrease. So far correct. Now let's go to the benefits. To do this, we have to see the company's ability to transfer cost increases due to inflation to its products. In this case, Microsoft has the ability, so if inflation rises, it should be expected to pass through to revenue and therefore profit.

The anomalous inflation of 2021 is due to a previous anomalous year, 2020. If one looks at the annualized rise from 2019 to 2021, one realizes that inflation in the Euro Zone is 2.3%, in Spain 2.3% .9% and in Germany 1.7%.

Now let's go to the amortization item. A company annually amortizes the cost of building the factory. If it was built ten years ago, the amortization is in relation to the cost and not what it would mean to build it again today. If you had to do it today, the cost would be much higher due to inflation, with which the amortization would be higher and, as a consequence, the benefit lower. And what is worse, if the amortization is less than it should be, the taxes on profits would be higher than they should be. Continuing with Microsoft, it does not have large factories, so the effect described above would not apply to the company.

Conclusion, although system one tells us that the denominator of the valuation rises, system two tells us that the numerator can rise equal to or more than what the denominator does (ability to transfer costs, little debt, low amortization…). Implying that the valuation is not affected only by the rate hike.

And what does system two say about inflation? The anomalous inflation of 2021 is due to a previous anomalous year, 2020. If one looks at the annualized rise from 2019 to 2021, one realizes that inflation in the Euro Zone is 2.3%, in Spain 2.9% and in Germany 1.7%. Levels that are within the range of the last ten years.