I've always found this sort of reasoning, which
permeates economics textbooks, amazingly
ideological. According to Wolf, if I buy a bond with a
coupon of 7% and I "expect" inflation to be 4% then
I am only really "earning" 3%. If suddenly I alter
my expectations -- I decide to think that inflation will
be 6%, then I am only earning 1%. The fact that
inflation proved to be lower than my expectations
(in fact has been running around 2.5%) -- the fact
that I am, in reality, walking away with a 4.5% return
matters not at all. Thus does the creditor class
explain away the reality of high real returns on
financial assets.
Ellen Frank
[EMAIL PROTECTED] writes:
>[Financial Times]
>A poor defence for share prices
>Many depend on the relationships between bond yields and earnings
>yields to value equities. But they are wrong to do so, says Martin
>Wolf
>
>To simplify, consider an irredeemable bond issued with a coupon of $7
>and a face value of $100, when the expected real rate of interest is 3
>per cent and expected inflation is 4 per cent. Suppose expected
>inflation falls to 2 per cent. If one ignores rounding errors, the
>price of the bond rises to $140 and the yield falls to 5 per cent. The
>owner of the bond has made a $40 capital gain - but the yield for any
>new purchaser gives the same real return as before.
>
>Now what does the fall in inflation do to the earnings yield and price
>of an equity? To simplify, the answer is absolutely nothing. To see
>this, assume for simplicity that the real return demanded from
>equities is the same as the real interest rate - the "equity risk
>premium" is zero. Assume also that the pay-out ratio is 100 per cent.
>The price of an equity expected to give earnings this year of $3 is
>$100. If inflation were to be 4 per cent, next year's equity price
>would be $104. If inflation were 2 per cent, next year's price would
>be $102. If one purchased a share and sold it next year, the money
>return would be $7 and $5, respectively, with $3 from the earnings and
>$4 and $2, respectively, from the rise in the price. The nominal and
>real returns would be the same as on the bond, as required.
>
>If inflation falls, the ratio of the bond yield to the earnings yield
>will fall but there will be no effect on the price of equities now.
>The change in the yield ratio will also say nothing about the
>advisability of buying shares. All it does is indicate an alteration
>in the expected path of future nominal earnings and equity prices.
>
>
