The statement: Other things being equal, an increase in inflation expectations would result in lower equity prices relative to current earnings. This would result in lower equilibrium P/E ratios.
Why does the increase in inflation expectations lower equity prices?
Higher discount rate on dividends or free cash flow.
How about if expected GDP is higher, would that increase equity prices at present?
Having major logically problems with the portfolio economics section – I think the text on CFAI is too difficult to understand and the Schewiser reading on this topic is so brief.
So from my understanding, a higher than exp GDP would:
encourage analysts model out higher growth rates for companies, especially cyclical firms which should lead to higher equity prices now.
due to higher expected GDP, the companies’ suppliers of capital would demand a lower required rate of return at present as cash flow uncertainty would reduce due to better business cycles.
one of the components of the discount rate is also inflation expectations, which would be high at present heading into a growth economy which is also expected to be priced in. This point is majorly dependent upon the Govt of that particular economy as by what frequency would interest rate hikes start given high inflation.
Overall, the outlook of positive future growth and higher certainty of cash flows outweigh the negatives of good economic growth(i.e. inflation) and hence must lead to an “increase” in stock prices.
P.S. - INVESTORS WILL ALWAYS GO OUT OF THEIR WAY TO PAY FOR GOOD GROWTH AND HENCE A BUMP IN EQUITY PRICES.