More on the impact of inflation on equities

A few months ago, Anthony wrote about inflation hedging (see here) and referred to an IMF paper which suggested that ‘traditional asset classes’, most notably equities, don’t fare well if inflation increases, which is something to bear in mind when trying to protect a portfolio against increases in the level of prices.

Francesco Curto at Deutsche Bank recently released a research piece that comes to similar conclusions. The article states that investors regularly use equities as an inflation hedge because of the view that nominal earnings and dividends rise faster when inflation is high, but this was not the case in the US during the 1970’s. Deutsche Bank show that over the last 50 years, while nominal returns on equity rose, real returns on equity actually fell.
The “smile” effect of inflation on returns

Deutsche’s research also shows that a fall in the PE ratio should be expected as inflation rises. For investors to be protected against inflation free cash flow would need to grow in line with inflation. If equities were a perfect inflation hedge, ceteris paribus,  then the PE ratio should remain unchanged as the share price and corporate earnings increase in line with inflation. The article does suggest that inflation hedging with equities may be possible, but due to the depressed levels of PE it could prove to be more costly than expected.

The S&P 500 PE ratio 1960-1995

Looks like bond investors and central banks aren’t the only ones that need to keep a close eye on inflation.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Categorised as: inflation

Discuss Article

  1. Trevor Rothermere says:

    Both John Hussman and Crestmont Research have published some good data on the impact of inflation on equities. Secular bulls are driven by the expansion of PE ratios from low to high; this expansion is driven by moves towards price stability (defined as low and stable inflation ~2%), whether this move is from deflation to low/stable inflation, or from high inflation to low/stable inflation.
    Therefore, during the initial phases of an inflationary period, equities historically perform poorly, as during this period PE ratios contract.
    Equities only begin to perform well after inflation has peaked, and PE ratios have already contracted in response. As the inflationary trend reverses, moving back towards price stability (low/stable inflation), PE ratios expand in response. It’s this valuation expansion that creates equity secular bull markets.
    Those who wish to make the case otherwise, and claim that equities perform well during the *entire* phase of an inflationary period should be prepared to publish the historic data that supports their claims. They’ll struggle.

    Posted on: 26/05/11 | 7:57 pm

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