Download Equity Investments as a Hedge against Inflation, Part 1

Investment Research
Equity Investments as a Hedge against
Inflation, Part 1
Werner Krämer,
Managing Director, Economic Analyst
The world economy has seen stable inflation over the last two to three decades, but this stable pattern is not observed
throughout a longer time period. When examining a longer series for world prices, we commonly observe episodes of
inflation or deflation, but not stability. The current high levels of sovereign debt, expansive monetary policies, and rising
commodity prices as a result of emerging market demand suggest an increasing probability of a change to recent inflation stability. A direct result of an increase in inflation would be for real returns on securities to suffer, particularly in fixed
income assets. As a consequence, many investors are seeking to secure the value of their investments by diversifying
into real assets. Real assets include not only “hard assets” like real estate, infrastructure, and natural resources, but also
equities, which in principle are a claim on tangible property.
In this paper we examine the suitability of equity investments to protect against the loss of value in inflationary or deflationary environments. In our view, the role of equities as an inflation hedge is a fundamental question that cannot be
answered concisely. On one hand, in inflationary periods real returns from stocks are greater than those of bonds and
are almost always positive. On the other hand, the inflation hedge is limited, explained by the negative correlation of
real equity returns and inflation: the higher the inflation, the lower the real return on stocks. The decline of real returns
on equities in the face of rising inflation can be strongly influenced by risk-averse investors. In high and volatile inflation
scenarios, investors become more risk averse and willing to pay lower prices in the stock markets.
2
Since the early 1990s (in some regions since the early 1980s), the
world economy has been marked by a rather unusual period of
growth. The progress of globalization and the associated increase in
competition in most markets have curbed inflation, despite relatively
high global growth. In many regions of the world, the rates of price
increases in the past two to three decades have steadily declined or
remained stable. This is in stark contrast to the 1970s, in particular,
when the world economy experienced severe stagnation (high inflation
and low growth) in the wake of oil price shocks (see Exhibit 1).
Exhibit 1
Developed Nations Have Experienced Stable Inflation over the
Last Two Decades
Year-over-year Change (%)
30
24
18
12
6
0
-6
1970
1974
1979
1984
1988
1993
1998
2002
2007
2012
Germany: Consumer Price Index
United Kingdom: Retail Prices Index All Items
United States: CPI-U All Items
As of March 2012
Source: Haver Analytics
Inflation over Two Decades
If we broaden our view to much longer time periods, low inflation is
not the normal state of the world economy. As noted in a paper by
Fels (2007), over the last two hundred years, the world’s economies
have been characterized by inflation or a pronounced deflationary
environment, but not by price stability. Using prices from Germany,
the United States, and the United Kingdom as an example, the study
shows that significant volatility in inflation was the norm. This means
that the unusually stable inflationary conditions of the last twenty to
thirty years have not entirely wrongly been called the “Goldilocks”
years or “The Great Moderation”.
Since the beginning of the latest global financial crisis, the specter
of inflation, much feared in 2007 and 2008 because of rising commodity prices, has largely been pushed to the side by political leaders.
Governments and central banks in recent years have correctly tried to
use expansive monetary and fiscal policies to prevent a meltdown of
the global economy and a relapse into recession or even depression.
The central banks have been inflating their balance sheets, though, as
if there were no tomorrow, as shown in Exhibit 2.
One could almost get the impression that inflation is now being
regarded by many leaders in strategic terms. It is often overlooked
that the recent decades of stable inflation, a condition desirable for
the economy, was a hard-won result of action by governments, central
banks, enterprises, and citizens. In times of private and public indebtedness as well as decades of comfortable low inflation, the fight against
inflation has subsided or is no longer a priority. The proponents of
globalization, free trade, and an open global economy are now on the
defensive with interventionist and protectionist forces on the rise.
Many market participants are gradually coming to the conclusion that
a little inflation cannot be all that bad. We believe that the interdependence of unbroken monetary expansion and government intervention
has become poisonous in its own right.
The Decade of Deleveraging
Undoubtedly, in our view, we are only at the beginning of government and private sector deleveraging in the developed world. While
there has already been a certain amount of private sector deleveraging
in the United States, Australia, and South Korea since the financial
crisis, national governments everywhere have continued to run up
their debt levels. In Europe, debt reduction across all sectors is just
beginning. Neither the states, nor the financial sector, nor private
households have been able to reduce debt ratios substantially. The
developed world is facing a decade of overall deleveraging, with all
sectors and countries reducing debt loads at the same time. This is a
situation that is difficult or impossible to accomplish as far as the balance mechanism is concerned (see Exhibit 3).
In such a situation, the investor must ask two questions: how can the
world economy accomplish the unavoidable deleveraging, and what
consequences will this have for various asset classes?
The negative experiences of strict austerity measures in the countries
on the European periphery, through the last two years, together with
declining concerns among financial leaders for the side effects of inflation, suggest that history could repeat itself. In the past, a combination
of higher inflation combined with governments forcing, either directly
or indirectly, investors to buy government bonds even with negative
real yields and other undesirable conditions played a major role in
deleveraging public-sector debt.
Exhibit 2
Central Banks Have Dramatically Expanded their Balance
Sheets
(USD trillion)
5
European Central Bank
U.S. Federal Reserve
4
Bank of Japan
People‘s Bank of China
3
2
1
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
As of June 2012
Source: ECB, FRB, BoJ, PBC, Haver Analytics
2012
3
This suggests that inflation could again play an important role in
achieving real debt relief in the coming decade. Acceptance of somewhat higher inflation rates over a longer period will help real debt
reduction but only if the higher inflation rates are not accompanied
by a substantial rise in interest rates. Given the extremely low interest
rates currently offered, this would only be accomplished with the help
of financial repression. Financial repression is the practice of governments issuing debt at lower rates than would otherwise be possible.
Essentially, the scenario of financial repression is a form of taxation on
bondholders and savers as interest rates are below the inflation rate. In
Exhibit 4 we show how this is now the situation in the United States
and Germany.
Searching for an Inflation Hedge
Against this background, it is not surprising that investors have been
busily searching for ways to hedge against inflation and safeguard
adequate long-term real returns since the outbreak of the European
sovereign debt crisis. In particular, continental European investors,
Exhibit 3
Deleveraging of the Developed World
Total debt (% of GDP)¹
500
Change (% of GDP)
2000–08
Japan
400
300
200
100
0
1990
92
94
96
98
2000
02
04
06
08
37
2008–2011Q2³
39
United Kingdom
177
20
Spain
145
26
France
89
35
Italy
68
12
South Korea
91
-16
United States
75
-16
Germany
7
1
Australia
77
-14
Canada
39
17
2011Q2
Significant increase in
leverage in recent period²
Deleveraging in recent period
1 Includes all loans and fixed-income securities of households, corporations, financial institutions, and government.
2 Defined as an increase of 25 percentage points or more.
3 Or latest available.
For the period 1990 to 2011Q2
Source: Haver Analytics, national central banks, McKinsey Global Institute
Exhibit 4
10-Year Government Bond Yields and Inflation in Germany and the United States
Germany
United States
(%)
9
(%)
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
10-Year German Bund Yield
Consumer Price Index
As of March 2012
Source: Bloomberg, Haver Analytics
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
10-Year U.S. Treasury Yield
CPI-U All Items
4
with their investment focus on nominal returns and financial assets
such as government bonds or money market products, are concerned
their investments will suffer real value losses if inflation rises sharply.
Conversely, they have profited nicely from twenty years of disinflation and occasional flirting with deflation. This reflationary fear is not
unfounded, because the (implicit) real interest rate of loans (as well as
money market products) varies greatly, and in times of high inflation,
is mostly negative, particularly if combined with financial repression.
It should be no surprise, then, that many investors in recent months
have become heavily interested in investments into real assets, either
to diversify their portfolios or to hedge against inflation, given that in
many instances real assets retain value since they appear less susceptible to inflation fluctuations. Most investors think of this category as
including all tangible, long-term, non-financial investments essential
for the economy which promise a real return or a real value. Although
the focus might be largely on assets such as real estate, infrastructure,
gold, minerals, or natural resources, corporate investments—i.e.,
shares—are in principle also a claim on tangible property. In contrast
to tangible and real assets, shares have several other distinct advantages: they are generally liquid, transparent, and hedgeable.
Equities and Real Returns
Equities represent a claim on the real economy and, more specifically,
of a particular company in the real economy. Therefore, one can
expect that real corporate profits (and the corresponding real stock
returns) will grow with the real economy, while nominal corporate
revenues (and the nominal share prices) will rise with inflation. Shares
would provide a complete hedge against inflation if their increase in
real value, adjusted for inflation, would be uncorrelated to inflation.
Unfortunately, that has not been the case in the past.
Based on a 19-country universe and with 112 years of annual equity
and bond return data, Dimson, Marsh, and Staunton (2012) classify
these returns according to the level of inflation as shown in Exhibit 5.
In times of very low inflation rates, especially during periods of strong
disinflation or even deflation, both equities and bonds have high real
returns. However, bonds significantly outpace stocks in the event of
severe deflation. Bonds are then a hedge against deflation.
However, besides a severe deflation, in all other inflation scenarios, the
real returns of stocks are higher than those of bonds, but the level of
real returns depends largely on the inflation rate. The perfect condition
for real returns from stocks seems to be very low inflation rates that do
not fluctuate greatly and exclude slipping into a genuine deflation. As
inflation rises, we observe that equity returns decline.
However, compared to fixed income, equities offer a certain degree
of protection from inflation in the sense that the real equity returns
are always greater than those of bonds during high inflation, and the
risk premium of equities tends to rise with the inflation rate. The real
returns of stocks are also basically positive in almost all inflationary
scenarios, except in times of extreme inflation. In significant inflationary periods, the real returns of both equities and bonds are negative.
To continue our analysis, we shift our focus to the correlation between
inflation and equity returns. As shown in Dimson, Marsh, and
Staunton (2012) a scatter plot of equity returns and inflation rates
reveals more complex results, as illustrated in Exhibit 6. As we previously stated, real equity returns tend to be lower with higher inflation
rates (a theoretical regression line would have a negative slope). The
correlation, however, depends on the specific country and its different
economic factors, its central bank’s policies, or corporate structures.
In addition, the dispersion in the chart speaks against a simple linear
relationship between inflation and real equity returns, and also refutes
inflation as a single explanatory factor of real equity returns.
And yet, most empirical studies carried out for decades can still make
one global assertion: Stocks outperform bonds in the event of rising
Exhibit 5
Real Bond and Equity Returns vs. Inflation Rates
Exhibit 6
One-Year Real Equity Return vs. Concurrent Inflation
Rate of return/inflation (%)
Real equity return (%)
20
10
20.2
150
11.9
11.2
6.8
11.4
5.2
0
0.6
10.8
3.4
1.9
7.0
2.8
2.9
8.0
100
5.2
1.8
50
4.5
-4.6
-3.5
-10
18.0
-12.0
-20
-23.2
-26.0
-30
Low 5 Next 15 Next 15 Next 15 Next 15 Next 15 Next 15
Top 5
Percentiles of inflation across 2128 country-years (%)
Real bond returns (%)
Real equity returns (%)
Inflation rate of at least (%)
0
-50
-100
-30
30
0
90
60
Inflation in prior year (%)
U.K.
U.S.
Ger
Jap
Net
Swe
Den
Spa
Bel
Ire
Fra
SAf
Ita
Swi
Aus
Nor
NZ
Fin
For the period 1900–2011
For the period 1900–2011
Copyright © 2011 Elroy Dimson, Paul Marsh and Mike Staunton
Copyright © 2011 Elroy Dimson, Paul Marsh and Mike Staunton
Can
5
and high inflation and provide a certain amount of hedging against
inflation when diversifying fixed income portfolios. Their ability to
offer investors protection against inflation is limited, however, by the
negative correlation between real stock returns and inflation as concluded
in Fama and Schwert (1977) as well as Boudoukh and Richardson (1993).
Inflation and Stock Valuation
From a purely empirical observation, we come now to the question of
why real stock returns are not independent of inflation and thus why
real stock returns do not simply depend on real growth. The answer to
this question is quite complex and the source of much controversy in
the literature (Tatom 2011). One reason is, however, quite simple: the
prevailing inflation regime has an influence on the market valuations
investors are willing to accept for equity investments. Rapidly rising,
volatile, or generally high rates of inflation cause increasing risk aversion
among investors which in turn leads to falling stock prices. Presumably
such an environment and the interest rate policies (of the government,
the central bank, and banks in general) generate uncertainty and make
it more difficult for companies to maintain their (real) growth in the
longer term. Also, when interest rates start to rise with inflation,
investment alternatives to stocks may become more attractive.
In Exhibit 7, based on U.S. data we observe that generally, higher
inflation rates correspond to lower stock valuations in terms of priceto-earnings (P/E) ratios. When inflation is low, we can see that P/E
ratios rise.
This relationship becomes even clearer if we view the data through
a scatter diagram of inflation and stock valuations, as illustrated in
Exhibit 8. In times of low and stable inflation (roughly between 2%
and 5%), investors many times accept high stock market valuations.
On the other hand, significant deflationary and inflationary environments lead to lower P/E ratios, explained in part by increased risk
aversion and uncertainty that characterizes inflation at both extremes
of the spectrum. Thus, the real stock returns achievable are to a large
Exhibit 7
Relationship of Price/Earnings Ratios and Inflation
Inflation Rate (CPI) (%)
30
extent dependent on the inflation environment, because as inflation
rises, equities as a rule may become cheaper.
Conclusion
Over the past two or three decades the world has seen an economy
marked with unusually low rates of inflation, despite normal growth.
This has been a result, in part, of globalization and deregulation, but
also successful monetary policy in most countries in the Organisation
for Economic Co-operation and Development (OECD). A look
further back in history reveals that this is not the normal state of
the world economy. In the past two centuries, more severe periods
of inflation or deflation were much more common than the stable,
“Goldilocks” scenario experienced in recent decades.
Given the high indebtedness of the public and private sectors in many
OECD countries, extremely expansive monetary policies, and rising
commodity prices as a result of booming demand from emerging
markets, many investors fear stable inflation may come to an end.
Particularly investors who own large allocations in assets such as government or mortgage bonds are worried that their assets might suffer
losses if inflation begins to run wild.
In this environment, many investors are looking to secure the real
value of their assets by diversifying into real assets. Real assets include
not only “hard assets” like real estate, infrastructure, and natural
resources, but also, acquiring stock in companies is in principle a
claim on tangible property. In contrast to the other real assets, shares
are highly liquid, transparent, and hedgeable. The empirical results in
studies that examined a long horizon of the real returns from equities
provide a contradictory picture. On one hand, almost all markets have
shown that, in inflationary periods, real returns from stocks are greater
than those of bonds and are almost always positive. In this respect,
adding equities to fixed income portfolios offers a certain degree of
real value preservation in the face of inflation.
Exhibit 8
Price/Earnings Ratios and Inflation
P/E Ratio
45
Inflation Rate (CPI) (%)
20
25
40
20
35
15
30
10
25
5
20
0
15
0
-5
10
5
-10
5
0
-15
1900
1920
1940
1960
1980
2000
Inflation Rate
P/E Ratio
15
10
5
-10
-15
0
5
10
15
20
25
30
35
40
45
P/E Ratio
For the period 1900–2011
For the period 1900–2011
Copyright © 2012 Crestmont Research (www.crestmontresearch.com)
Copyright © 2012 Crestmont Research (www.crestmontresearch.com)
6
On the other hand, the inflation hedge is limited, because the correlation of real stock returns and inflation is negative. The higher
the inflation, the lower the real returns from equities. However, real
returns only become negative in extremely high inflation. As inflation rises or becomes more volatile, uncertainty sets in and investors
become more risk averse, and real returns on equities fall as investors
demand lower valuations in the overall equity market.
We have limited the first part of our analysis with some strong
assumptions and generalizations. As we continue to explore the theme
of optimal tools to combat inflation, we will raise other fundamental
questions: Can one get different results by differentiating between the
short and long terms? Are there any industries whose stocks are more
likely to hedge against inflation than the overall stock market? Is it
possible to compile a portfolio of individual stocks with better hedge
results against inflation than indexes? What other equity-related asset
classes are (more) appropriate for an inflation hedge?
References
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Boudoukh, Jacob and Matthew Richardson. “Stock Returns and Inflation: A Long-Horizon Perspective.” The American Economic Review, December 1993.
Chadha, J.S. “World Real Interest Rates: A Tale of Two Regimes.” Working paper, DWS Global Financial Institute, February 2012.
Chakrabortti, Abhijit. “Sudden Impact – Inflation and Equity Valuations.” J.P. Morgan North America Equity Research, September 2008.
Crestmont Research. P/E Ratios & Inflation, 2012, http://www.crestmontresearch.com/docs/Stock-Inflation-and-PE.pdf
Dimson, Elroy, Paul Marsh, and Mike Staunton. “Credit Suisse Global Investment Returns Yearbook 2012, The Real Value of Money.” Credit Suisse, February 2012.
Dimson, Elroy, Paul Marsh, and Mike Staunton. “Triumph of the Optimists: 101 Years of Global Investment Returns.” Princeton University Press, 2002.
Fama, Eugene and G. William Schwert. “Asset Returns and Inflation.” Journal of Financial Economics, 1977.
Fels, J. “What do 187 Years of Data Tell Us About Inflation?” Morgan Stanley Research Global Economics, October 2007.
Fischermann, T. and P. Pinzler “Die tägliche Wasserschlacht – die Welt verstrickt sich in Handelskriege [The Daily Water Fight: The World Ensnared in Trade Wars].” Die Zeit, April 2012.
Giannone, Domenico, Michele Lenza, and Lucrezia Reichlin. “Explaining the Great Moderation.” European Central Bank Working Paper No. 865, February 2008.
Krämer, Werner. “Rohstoffe als Investmentklasse [Raw Materials as an Investment Class].” Lazard Asset Management, Background Paper, June 2002.
Roxburgh, C., et al. “Debt and deleveraging – Uneven Progress on the Path to Growth.” McKinsey Global Institute, Updated Research, January 2012.
Sbrancia, M. Belen. “Debt and Inflation during a Period of Financial Repression.” White Paper, Department of Economics, University of Maryland College Park, December, 2011.
Slok, T. “Under Which Conditions Will Fed Money Printing Create High Inflation?” Presentation, Deutsche Bank Global Markets, New York, March 2012.
Tatom, John. “Inflation and Asset Prices.” Working Paper, Networks Financial Institute at Indiana State University, November 2011.
Wilson D., et al. “The Paths Out of Public Debt Build-ups.” Goldman Sachs Global Economics Weekly, April 2012.
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Published on 14 August 2012.
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