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INSIGHT
Volume 34 – May 2011
INFLATION:
IN THIS ISSUE
The Influence of Inflation on Equity Returns
The Basics
Is Inflation Bad for Equity
Returns?
Developed Market Stock
Returns vs. Inflation Rates
What is a Good Inflation
Hedge?
Developing Market Stock
Returns vs. Inflation Rates
Is Deflation Bad for Equity
Returns?
Copyright © 2011
Mawer Investment Management Ltd.
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versions of this article. To order reprints
or receive an electronic copy, please
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2
Volume 34 – May 2011
INFLATION:
The Influence of Inflation on Equity Returns
Is inflation bad for equity returns? Is deflation bad for equity returns?
Should I be selling my U.S. stocks if the American Consumer Price
Index (CPI) is high? If there are high inflation rates, should I be buying
stocks? In this article we will review how inflation affects equity
investments, and we will find that there are no set investment rules
when it comes to inflation.
THE BASICS
Each investment in a bond or stock is a claim on a series of future
cash flows. These can be coupon and principle payments for bonds,
or earnings for stocks. Inflation reduces the purchasing power of
cash and, therefore, reduces the value of such future cash flows. If
investors expect inflation to be high in the future, then they require
higher rates of return today.
This relationship is most easily observed in bond investments. All else
being equal, bond yields will increase as inflation expectations increase.
The higher yields result in lower bond prices in secondary markets,
higher coupons on new issues, and higher reinvestment rates for the
interest received. While this relationship is fairly straightforward, how
inflation affects equity investment returns is a much more complex
topic and subject to disagreement between experts.
Unlike a bond, the future cash flows of an equity investment are
not limited to the coupon stipulated in an offering document. To
understand how inflation may affect returns for an equity investor,
one has to postulate how inflation affects future company earnings
and dividends. Although higher future prices bode well for revenues as
a company can increase charges to its customers for its products and
services, higher prices are also likely to increase its wages, borrowing
rates, raw materials, and rent. Thus, while the company increases its
sales, it also must pay more to operate.
IS INFLATION BAD FOR EQUITY RETURNS?
Equity investments, along with real assets such as commodities or
real estate, are often said to be an “inflation hedge”. This term refers
to an investment with rates of return that are greater than, or equal
to, the rate of inflation. As costs increase, a company will try to pass
these expenses on to its customers, thereby increasing revenues and
maintaining net cash flows. The result is that cash flows are protected
from the affects of inflation and continue to accrue to the equity
investor. Unfortunately, this depiction of stocks is incomplete.
It is common to measure inflation with indices based on averages of
prices of consumer products such as the Consumer Price Index (CPI).
But costs and sales for a single product or company will increase at
different rates than those shown by the indices, and the ability of each
company to mitigate increased costs by increasing sales will vary. If a
company cannot increase revenues to fully compensate for increases in
its costs, the profit margins for its shareholders will decline. The higher
and more volatile inflationary rates become, the more companies are
at risk for declining margins. Clearly, the term “inflation hedge” is
undeserved for many companies.
Inflation can also create headwinds for equity as an asset class. Higher
inflation expectations increase interest rates which in turn increase
the yields on bonds. When an investor buys stocks, they expect a rate
of return higher than if he or she bought bonds. It follows that to
maintain a current stock price when investors have high expectations
for inflation, the expected rate of return for equity investments must
also increase to compensate for the relative value of bonds. But,
even if a company has the good fortune to be able to pass 100% of
its cost increases to its customers, this does not necessarily translate
to an increase in profit margins or an increase in the rate of return
for shareholders. All things being equal, it would appear that higher
inflationary expectations will tend to depress stock prices and reduce
shareholder returns.
For example, let us hypothesize that inflation rates are very high, 10
to 20%. High and volatile inflation rates tend to increase inflation
expectations so that interest rates become prohibitively high for equity
investments. Imagine that a Government of Canada bond yields
15% because inflation expectations are near 12%. A high quality
corporate bond issue would contain greater risk than the government
bond, and must yield over 15%, say 17%. For a shareholder of the
same corporation, the return on their equity must yield over 17%
to compensate for the increased risk of holding stock rather than
a corporate bond. Because there is nothing about an inflationary
environment that necessarily leads to increased company profitability
and return on equity, the stock price may have to decline to entice
buyers with higher expected returns.
DEVELOPED MARKET STOCK RETURNS VS.
INFLATION RATES
Admittedly, we have painted a negatively biased picture for stock
returns as they relate to inflation. A review of two major equity
indices, the S&P/TSX Composite Index and the S&P 500, provides
some evidence as to why many call for buying equity as protection
from inflation.
In Figure 1, we have taken the difference between 10 year annualized
total returns for the S&P/TSX Composite Index and 10 year annualized
Canadian CPI rates. For the past 15 years, equity returns for this
index have convincingly outpaced Canadian CPI increases. In fact,
since 1995 the S&P/TSX total returns have exceeded CPI by 7.5% on
average. This period in Canada has been characterized by relatively
low, stable inflation.
In the late 1980s and the early 1990s, inflation was much higher and
more volatile, and equity annual rates of return above annual inflation
Volume 34 – May 2011
been between 5 and 10%, there is a greater risk that equity returns
will not outpace inflation rates. This was the case in the early 1970s
for the domestic U.S. investor and in the early 1980s for the domestic
Canadian investor.
rates were not as common. As demonstrated in Figure 1, stocks do
not provide much inflation protection during this period. In 1990, a
person invested in the S&P/TSX Composite Index would have failed
to beat inflation rates over the past 10 years.
WHAT IS A GOOD
INFLATION HEDGE?
The Difference Between 10 Year Annualized S&P/TSX Composite Total Rates of Return and Year Over Year Canadian CPI
12.00%
There are a few ways to invest in
equity and reduce the risk that
inflation presents. The key is in
investing in companies with the right
business model and in understanding
how inflation expectations affect
stock prices.
10.00%
8.00%
Rate (%)
6.00%
4.00%
2.00%
0.00%
Figure 1 Source: Bloomberg
In the U.S., the past 20 years are characterized by stable, low inflation
while the 1970s show mostly high, volatile inflation rates. Figure 2
provides complementary analysis to Figure 1 using total returns of
the S&P 500 and U.S. CPI values. 10 year equity returns failed to beat
inflation rates in the early 1980s, but throughout the 1990s, and
much of the new millennium, equity returns provided growth above
inflation rates. It is important to note, however, that an investor in
the S&P 500 Index would have failed to beat inflation over the past
10 years as of the end of 2008, 2009, and 2010.
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Some businesses may find themselves
benefiting from higher interest rates.
A good example of such a business
is Manulife Financial Corporation.
Insurance businesses benefit from increased profits when interest rates
are greater than those assumed in their previously written insurance
policies. Trust companies can also exhibit similar characteristics.
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
-2.00%
-4.00%
Aside from the type of business, we need to understand the difference
between investing in a company and investing in the stock of a
company. Expectations about inflation can affect stock prices to
compensate the equity investor for inflation. Consider if the general
market consensus is that inflation will be 2% on average over the
next 10 to 15 years. If I buy a stock at fair value today, the price of the
stock will already have factored in the 2% inflation rate. If inflation
expectations suddenly jump to 5%,
The Difference Between 10 Year Annualized S&P 500 Total Rates of Return and Year Over Year US CPI
then there is a greater chance of the
stock price declining. If I buy a stock
at fair value when the expectations for
inflation are 5%, then a realized 5%
inflation rate does not have the same
negative effect on the stock price.
20.00%
15.00%
Rate (%)
10.00%
5.00%
Figure 2 Source: Bloomberg
What can we learn from this analysis? Over the past 30 years, observed
equity returns have exceeded inflation rates and provided growth in the
purchasing power of assets most of the time. During this period, equity,
as an asset class, can be generally described as a good investment to
beat inflation. Be that as it may, equity investments are not surefire
inflation hedges. When 10 year average annual inflation rates have
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
0.00%
-5.00%
3
Overall, some stocks can be considered a
good inflation hedge. The keys are to find
the right business model and to purchase
a stock at a price that adequately
considers inflation expectations. In this
way, an investor can protect his or her
portfolio or even benefit from an increase
in inflation expectations.
DEVELOPING MARKET STOCK RETURNS VS.
INFLATION RATES
The relationship between inflation and equity returns increases in
complexity for the international investor. Figure 3 below expands on
the analysis above using the equity market of Brazil. Brazil was chosen
as an example because of its prominence as an emerging market and
the extreme annual inflation rates Brazil has experienced in the past.
Volume 34 – May 2011
In Figure 3, the first graph compares 10 year annualized total Brazilian
real returns for the Bovespa Index with Brazilian CPI. Like developed
markets, Brazilian equity returns as measured by the Bovespa Index
generally exceed inflation rates. The second graph in Figure 3 depicts
the difference between the 10 year annualized Bovespa Index total
returns in Canadian dollars and Canadian CPI. It would appear that
Brazilian equity, on average, has provided an inflation hedge to the
Canadian investor over the past seventeen years.
8.00%
6.00%
4.00%
2.00%
Jan-04
0.00%
-2.00%
Jan-10
Rate (%)
10.00%
Jan-08
12.00%
Jan-07
14.00%
Jan-06
16.00%
In addition, notice that only 10 year annualized rates since 2004 have
been included in the graphs. Reliable and accurate measurement of
inflation and equity returns in Brazil are difficult to obtain prior to
1994, when the current Real was
The Difference Between 10 Year Annualized Bovespa Total Rates of Return (BRL) and Year Over Year Brazilian CPI
adopted as the currency of Brazil. The
difficulty arises because prior to 1994
Brazil experienced a number of years
of extremely high inflation rates. For
example, the annual inflation rate in
1993 was well over 2,000%! Such
extreme, runaway inflation rates are
often termed as hyperinflation. With
this kind of inflationary changes,
measurements like CPI are significantly
biased and hence it is difficult to
create comparisons like the ones for
the S&P/TSX Composite and the S&P
500 indices.
Jan-05
18.00%
hedge. High inflation in a foreign country will reduce the value of its
currency relative to our own, all else equal. This has a negative affect
on Canadian Dollar returns. Given this increased risk, Brazilian equity
was not an effective inflation hedge when compared to investing in
Canadian equity alone.
Jan-09
4
Hyperinflation is a significant risk in
developing markets such as Brazil’s.
Its effects and causes are subject for
an entire article on its own, but two
comments can be said here:
The Difference Between 10 Year Annualized Bovespa Total Rates of Return (CAD) and Year Over Year Canadian CPI
12.00%
10.00%
Rate (%)
8.00%
1) hyperinflation negatively affects
trade and productivity in an
economy such that many equity
investments would be at serious
risk of capital loss,
6.00%
4.00%
2.00%
Figure 3 Source: Bloomberg
At first glance, a Canadian investor buying Brazilian stock does not
appear to be at a disadvantage in comparison to a Canadian investor
buying Canadian equity, however, there is more to the story than what
is shown in these graphs.
The Bovespa Index Brazilian Real total returns have outpaced Brazilian
inflation rates to a greater extent than the same index Canadian
Dollar returns have outpaced Canadian inflation rates. For most of
the time period examined, the Brazilian Real was weak against the
Canadian Dollar. This is the challenge for international investors:
exchange rate movements may reduce the effectiveness of the inflation
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
-2.00%
Jan-04
0.00%
2) holding a currency that rapidly
depreciates in value is not desirable
to say the least.
The international investor can also note that the opposite of the above
scenario with Brazil, is also true. If domestic inflation rates are higher
than inflation rates of a foreign country, then the value of the foreign
currency will appreciate relative to domestic currency, all else being
equal. This has a positive affect on returns and enhances the ability
of equity, or any other investment in the foreign currency, to exceed
domestic inflationary rates.
SUMMARY
There is always a risk that returns on equity investments insufficiently
grow above inflation rates. When inflation is low and stable, stock
prices can adequately adjust for inflation expectations. As inflation
5
Volume 34 – May 2011
created. In its extreme form, sometimes called debt deflation, the cycle
can lead to a price decline similar to the Great Depression or what
was observed in 2009. In this case, deflation is coupled with a major
contraction in production that reduces profits and plunges the prices
of stock. In this case, deflation is definitely bad for equity returns.
rates increase or unexpectedly rise, the ability of equity returns to
rise above inflation rates is reduced. In Canadian and U.S. equity
markets, this risk was realized after the high inflation rates of the
1970s and 1980s. With international investing comes exchange rate
risk, which could be negative or beneficial to equity returns and their
inflation hedging ability. We can conclude that holding equity over
the past 15 years has, in most times, been a good way to beat low to
moderate inflation rates. A review of market returns, however, may
call into question whether or not equity can be accurately called an
inflation hedge.
Others worry that deflation is a signal of economic and stock market
conditions similar to that of Japan. Figure 4 sums up the Japanese
equity investor’s experience over the past 40 years. From 1971 to
1989, there was only one year, 1986, where the Japanese experienced
deflation rather than inflation. ¥100 invested in the Nikkei 225
Average at the start of 1971 would be worth ¥1958 at the end of
1989. Japanese CPI increased at an annualized rate of 5.1% over the
same period. The next 20 years tell a strikingly different story. ¥100
invested in the Nikkei 225 Average at the start of 1989 was worth
only ¥31 at the end of 2010. Japanese CPI turned from inflation to
deflation early in this period with an annualized rate of 0.4%. From
the start of 2000 to the end of 2010, the annualized rate of inflation
(deflation) was -0.2%.
An active investor can take a few steps to find good inflation hedges
in international equity markets. First find a business model that is less
susceptible to negative affects of inflation. Second, build inflation
expectations into the value of the stock. Finally, evaluate the inflation
environment of the foreign economy in addition to the domestic one
when investing internationally.
IS DEFLATION BAD FOR EQUITY RETURNS?
There is little experience in financial markets with deflationary
economies. From what has been
observed, many believe that deflation
50.00
has led to losses in stock markets
40.00
mainly due to debt.
Annual Japanese CPI and Annual Nikkei 225 Total Return (Yen)
30.00
20.00
10.00
Rate (%)
0.00
-10.00
-20.00
-30.00
2009
2010
2010
2008
2007
2006
2005
2009
Japan CPI
2004
2003
2002
2001
2000
1999
1998
1997
-50.00
1996
-40.00
1995
A consumer can separate the
time when a good is consumed
and when he or she pays for that
consumed good by borrowing cash
at the time of consumption. Over
the time of the loan, a proportion
of wages must go to paying for
past consumption, thereby reducing
current consumption. If there is a
general increasing trend amongst all
consumers toward paying past debts,
overall demand for goods will decline,
which will result in a price decline. A
reduction in aggregate demand is not
a good sign for corporate profitability
and over time should lead to lower
stock returns.
Nikkei 225
Annual Canadian CPI and Annual Nikkei 225 Total Return (CAD)
50
40
30
20
Canadian CPI
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
Rate (%)
10
If inflation reduces the value of
currency then deflation increases its
0
value. This provides an incentive to
-10
further delay current consumption
-20
in favor of debt payments for past
-30
consumption because the dollars
-40
used for debt payments are worth
more every day. The reduction in
current consumption places further
downward pressure on prices. Thus, a positive feedback cycle is
Nikkei 225
Figure 4 Source: Bloomberg
6
Volume 34 – May 2011
There has been little growth of the Japanese economy since the start
of 1990, which means that there has been little growth in corporate
profitability. This helps to explain the poor returns of the stock market.
Since this poor growth and equity returns have happened at the same
time as the Japanese economy transitioned from an inflationary to a
deflationary economy, it would appear that the two are linked. If this
is truly the case, then deflation is the harbinger of poor equity returns,
and the purchasing power of an investor’s portfolio will increase only
by holding cash or bonds.
An interesting analysis that runs counter to these fears was provided
in the revised edition of the Intelligent Investor by Benjamin Graham
with additional commentary by Jason Zweig published in 2003. Zweig
reproduces part of a study from Ibbotson and Associates “2003 Stocks,
Bonds, Bills, and Inflation Yearbook.” He reports that since 1926 to
2002, there were 10 deflationary years in the US. In three of these
years, deflation was under -5% and stock returns were well beneath
-20%. These appear to be the extreme debt deflationary scenarios as
described above. In six of the other seven years, stock market returns
exceeded 10%, with the highest two annual returns over 50%. In
the final deflationary year, stock returns and inflation annual rates
were near 0%. From these U.S. observations, it would appear that
mild deflationary rates have not always resulted in negative stock
market returns.
In “A Monetary History of the United States 1867-1960” Milton
Friedman and Anna Jacobson-Schwartz provide observations that
also challenge the link between deflation and declining productivity.
A secular deflationary trend persisted in the U.S. for approximately
30 years following the Civil War. However, to quote the authors
when comparing this deflationary period with the inflationary 20
years after it:
Deflation appears to be negative for stock returns as it relates to a
debt deflation cycle of a serious recession because it creates incentives
that deepens that recession. Outside of this scenario, it is difficult to
determine if a deflationary economy is a negative for equity markets.
MAWER’S TAKE ON IT
Mawer creates broadly diversified portfolios of wealth-creating
companies bought at a discount to our estimate of their intrinsic
value. As aforementioned, it is important to adequately build inflation
expectations into the value of a stock. Purchasing stock at a discount
to its intrinsic value help us provide a degree of protection against
unexpected changes in inflation. By purchasing high quality businesses
with strong competitive advantages, the companies in our portfolio are
also more resilient to prolonged and severe recessions that accompany
a debt deflation cycle. Our strategy helps to protect the value of our
equity portfolios over the long-term.
A part of our investment process is to regularly review the risks
of inflation and deflation and make adjustments to our portfolios
accordingly. These adjustments may include favouring one stock over
another or implementing a shift between asset classes. Additionally,
we diversify our investments globally in order to mitigate the risk of
exposure to any one particular country’s inflation rate volatility.
Gavin Preston, CFA
Portfolio Manager, Private Client Portfolio Management
Mawer Investment Management Ltd.
In the two final decades of the nineteenth century [there] was a
growth of population of over 2 per cent per year, rapid extension of
the railway network, essential completion of continental settlement,
and the extraordinary increase both in the acreage of land in farms
and the output of farm products…manufacturing industries were
growing even more rapidly….A feverish boom in western land swept
the country during the eighties…generally declining or generally
rising prices had little impact on the rate of growth….This evidence
reinforces the tentative conclusion reached…that the forces making
for economic growth over the course of several business cycles are
largely independent of the secular trend in prices.
1 Graham, B., & Zweig, J. (Revised 1973 edition) Intelligent Investor. HarperBusiness Essentials, 2003,
p. 62
2 Friedman, M., & Jacobson-Schwartz, A. (1971). A Monetary History of the United States 1867-1960. New Jersey: Princeton University Press.
All information contained herein has been collected and compiled by Mawer Investment Management Ltd. All facts and statistical data have been obtained or ascertained from sources,
which we believe to be reliable but are not warranted as accurate or complete. All projections and estimates are the expressed opinion of Mawer Investment Management Ltd. and
are subject to change without notice. Mawer takes no responsibility for any errors or omissions contained herein, and accepts no legal responsibility from any losses resulting from
investment decisions based on the content of this report. This report is provided for informational purposes only and does not constitute an official opinion as to investment merit.
Based on their volatility, income structure or eligibility for sale, the securities mentioned herein may not be suitable for all investors.