This is good for equities. Since 1989 - when CPI data began - there's been a strong correlation, of 0.72, between inflation and the dividend yield on the All-Share index. A one percentage drop in inflation has on average been associated with a 0.33 percentage point lower yield - equivalent to an 11 per cent rise in share prices.
There's a simple reason for this. When inflation is low investors expect interest rates to stay low. And low interest rates mean that future dividends are discounted by less, which means that share prices are higher relative to current dividends.
What's more, there's also a correlation between the unemployment rate and dividend yield. Controlling for inflation, a percentage point fall in unemployment has been associated (in average since 1989) with a 0.16 percentage point lower yield - equivalent to a share price rise of 5 per cent. Again, there's a good reason for this. Low unemployment is a sign of a strong economy, and in such circumstances investor appetite for risk is usually high - which means high equity prices.
Since 1989, fluctuations in unemployment and inflation have explained three-fifths of the variation in the dividend yield. And when the yield has been a long way from that predicted by the economic fundamentals, it has often been a sign that shares have been mispriced. For example, in the technology bubble of 1999-00 and in 2011 the yield was below that predicted by inflation and unemployment, and shares subsequently fell and the dividend yield rose. Conversely, in 2003 and 2009 the yield was higher than predicted - and it subsequently fell and share prices rose sharply.
Right now, the dividend yield is roughly where inflation and unemployment predict it should be, suggesting the market is reasonably valued - as it should be. This is not as dull as it seems. It implies that if inflation stays low and unemployment falls further, as most economists expect, then we should see the All-Share index rise this year.
