Have You Considered the Ground Beneath Your Feet?

11.04.2017 • United Kingdom

By Dan Denning – Southbank Investment Daily (Great Britain) –

A quick scan of the headlines reveals nothing earth-shattering. I can get back to the point I was trying to make yesterday about what most economists miss when looking at wealth creation. It’s the ground under their feet.

Before that, one brief note about inflation in the UK. It ran at 2.3% in March, according to the Bank of England (BoE). That’s above the BoE’s target of 2%. And as Charlie Morris says, gold likes inflation – hence the nice run by Randgold and Fresnillo on the FTSE in early trading action.

Watch out for 4% though. That was the number Charlie’s friend Peter Warburton mentioned in his presentation a few weeks ago. It’s the level of inflation that starts to punish stocks. Why? Because investors start to have second thoughts about the current value of future cash flows.

It all comes down to the time value of money, which sounds like a more complicated concept than it actually is. Think about it this way: a promise to pay you £1,000 pounds you’re scheduled to receive in 2023 is worth less to you than £1,000 in your hot little hand today. With inflation, £1,000 in 2023 won’t have the same purchasing power. And you have six years of risk in between where any number of events could make that £1,000 worth even less.

The discount rate helps you determine what you should pay today for that future £1,000, given inflation and the risks that may come up in the six years before you get paid. The greater the discount rate, the more uncertain you are. Which has, what, exactly, to do with why 4% inflation is bad for equities?

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