Tuesday, August 4, 2009

How do equities do under inflation? - Ari Paul

Does moderate inflation make equities more attractive? What about severe inflation? The historical data in the US is clear; periods with 6% or higher inflation have always produced negative real returns for equities. The simplest explanation for this comes from the "Fed model"; inflation raises nominal bond rates which compete with equities for space in your portfolio. If inflation is 10% and bond yields are 11%, you're going to require a higher yield to own equities, so equities must sell off to provide that yield.

But why do equities need to sell off to provide a higher yield? Wouldn't inflation increase a company's sales and therefore its return on equity to provide those higher yields? Warren Buffett wrote an excellent piece on the question back in 1977 (http://www.valueinvesting.de/en/inflation-equity-investor-by-warren-buffett.htm). Buffett examined all the sources of return on equity and concluded that inflation doesn't really benefit any of them. While sales increase in dollar terms, that extra cash has to be spent on the more expensive capital just to sustain the same volume. Moreover, the real price of debt increases because lenders become more hesitant; higher inflation rates are inherently unstable so lenders require a greater interest rate spread between their borrowing and lending rates.

Over the last 100 years, return on equity has been remarkably stable right around 12%. While it's intuitive to expect returns to increase with inflation, they haven't for the reasons discussed above. Inflation also increases frictional costs throughout the economy (like a storeowner who has to apply new price labels to her products every month) and reduces real GDP. The net effect is that inflation acts very similarly to a tax. An increase in inflation from 0% to 5% is likely to reduce real return on equity by 5%. This means stocks need to sell off to produce the same real return as before.

So equities perform poorly under inflation rates over 6%. With inflation over 9%, they are likely to underperform land and commodities. What about low inflation of 3% or lower? It's difficult to separate cause and effect, but equities have tended to do best with 1-3% inflation. The difficulty in analysis comes from the fact that levels of inflation below 1% generally appear during recessions and depressions which are obviously bad for stocks. Still, there is a good case to be made that low levels of inflation are generally good for the economy because they increase aggregate demand and encourage the "animal spirits" of entrepreneurialism.

Are equities a good inflation "hedge"? It's true that equities are likely to do much better than cash under sustained inflation, but you're still losing purchasing power and underperforming everything from short-term debt to real estate. Still, equities provide a good balance of partial protection under severe inflation, and the best investment under low levels of inflation.