Inflation concerns are turning into quite the balancing act for equity investors. If it stays low for too long it could raise doubts about the country’s long-term growth, but steadily rising inflation has typically driven valuations down and could lead to concerns that the Fed won’t be able to manage inflation while unwinding QE in an orderly fashion.

S&P 500 could be 10% overvalued

“Low inflation, despite aggressive central bank stimulus, has raised concern among equity investors about long-term trend growth. Lowering our trend CPI or GDP assumption by just 10 bp reduces our equity fair value by 1-2%,” writes Goldman Sachs analyst Stuart Kaiser. “Revenue growth has a closer link to inflation than earnings or margins.”

But that 10 basis point reduction could turn out to be quite conservative. Kaiser writes that assuming long-term inflation of 1.7% instead of 2%, and GDP growth of 2.3% down from 2.5%, would lower the S&P 500 (INDEXSP:.INX) fair value estimate by 10%. This isn’t an unimaginable scenario – inflation expectations are quite low by historical standards.

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Rising inflation usually a drag on valuation

On the other hand, rising inflation could surprise investors who now expect inflation to stay below the Fed’s target rate for the foreseeable future, and normally pulls valuations down.

“Rising inflation is a headwind for S&P 500 (INDEXSP:.INX) valuation. There has been a reasonably strong and negative relationship between inflation and S&P 500 P/E valuation using forward earnings estimates (since 1975) or trailing earnings (since 1930),” writes Kaiser. He notes that the dot com bubble skews the results somewhat because it was a period of very high growth and low inflation, but not so much to change the underlying trend.

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“Over the past two years the companies with the highest beta to inflation expectations are in cyclical sectors, have higher debt/EV levels, and more operating leverage,” writes Kaiser.

Cyclicals are the most sensitive to inflation, unsurprisingly. Energy, autos, and some financials have particularly high beta to changes in inflation, while hardware, food and health care equipment stocks are some of the defensives that are least impacted by inflation. Tech stocks also appear to be relatively unaffected by inflation, but this data goes back to 1988 and includes the dot com bubble, so there could be some sector specific skewing here.

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