This article was originally published in the NBR
Most developed economies haven’t had a major stint of inflation in at least 30 years. In the US, it has been almost 40 years since inflation last spiked meaningfully above 5%. This means that very few investors have any practical experience with investing in an inflationary environment. Given the backdrop of supply chain disruption and surging prices, it may be timely to consider the implications of inflation for the investment landscape.
Inflationary headwinds beginning to hit corporates and consumers alike
It is hard to ignore the effects of inflation currently at play in the economy. Post-Covid supply chain pressures have resulted in low inventories and delays in getting our hands on many everyday items. Have you tried buying furniture lately? Expect a 6-week to 6-month delay. Shipping costs have tripled over the last year. Oil prices have doubled and are back above $80 a barrel - hitting motorists in the pocket. Surging power prices are also causing problems in selected markets. Even used car prices are up nearly 40% due to curbs on new auto production caused by a shortage of semiconductors.
At an aggregate level we see these pressures in the reported inflation data. We saw it first in the US, where inflation hit 6.2% in its most recent reading. But we have since seen inflation pick up in Europe and the UK, and most recently in New Zealand, where CPI inflation hit 4.9% in the third quarter.
Rising prices and supply chain issues are also starting to hit the corporate sector, with a large number of US companies calling out these factors as a major detractor from performance in the most recent US reporting season. Amazon summed it up well in their recent earnings press release, saying that they "expect to incur several billion dollars of additional costs…as we manage through labour supply shortages, increased wage costs, global supply chain issues, and increased freight and shipping costs".
When does inflation become a problem for markets?
A certain amount of inflation is expected and manageable for investors. The real question is at what level inflation starts to become problematic - not just by gradually eroding the purchasing power of your savings – but by causing a spike in the risk premia investors demand. At a certain level inflation also acts as a meaningful tax on consumption and growth (eg. through higher fuel prices) – which causes inflation to have real world impacts and not just monetary effects.
The chart below looks at the relationship between inflation and US equity market returns over the last 100 years. It ranks all 100 years from the lowest to highest inflation outcome (the red bars), and then shows the corresponding US equity market return in that year (blue bar).
As would be expected, inflation has limited bearing on equity returns most of the time. It is only when inflation is at its extremes (both high inflation and deflation) that it becomes problematic. As the left-hand side of the chart shows, in times when consumer prices are falling, equity returns have been terrible. At the other extreme, in the 14 years when inflation has been above 6%, equity returns have been negative on eight occasions. The average return over those 14 years was just 2% - so well below the rate of inflation.
The 70s called. They want their inflation back
The experience with high inflation in the US in the 1970s is also a useful period to reference. It was around this time the term stagflation was coined. The US witnessed high inflation over this period on the back of a spike in commodity and oil prices (driven in part by OPEC constraining supply), which subsequently drove a price and wage spiral. From 1973 to 1982 US consumer prices increased by 130% – or an average of almost 9% per annum. This decade of inflation reduced the purchasing power of a dollar by over 55%. Over this period equities delivered a return of c.7% per annum, resulting in a real (post-inflation) return of negative 2% per annum.
This shows that there are instances where sustained inflation has done some long-term damage to equity portfolios. It is worth keeping this in perspective however – it was a rare event. It was also the only 10-year period in the last 100 years that US investors have received a negative real equity market return - outside of the Great Depression and the 10 years that included both the dotcom crash and the Global Financial Crisis.
After 30-40 years with limited inflation, the most recent spike provides a timely reminder that it is still a risk. It has also caused many investors to start looking for assets that may protect their portfolios from inflation.
Inflation protection doesn’t always work as expected
If you had 100% foresight and saw inflation coming this time last year, what would you have done?
A lot of traditional macro investors would have suggested loading up on gold as an inflation hedge. Expecting that a bout of inflation would push gold prices higher. If that was your trade – selling shares and buying gold - then you would currently be very disappointed. Over the last year gold is down 2%, while global shares are up 25-35% in many markets. We have seen inflation everywhere – except the one place that many investors expected to see it.
My point is that trying to invest based on macroeconomic forecasts is a tough game. Even if you guess the economic scenario right, you must still pick which investments will benefit. All of this makes it about as easy as predicting what the weather will be like two months from now.
Are equities a good inflation hedge?
One theory is that equities can help hedge inflation. The theory is that a company should ultimately be able to pass increasing costs through to its customers. This should help protect it from the impacts of inflation – at least over the long term. This isn’t always the case, however. As we saw with the 1970s example, equity investors experienced negative real returns for a decade.
US fund manager GMO recently published an article on the types of listed companies that do the best in inflationary environments. Studying the eight periods in the US when inflation spiked above 5% for more than a year between 1933 and today, they found that high quality businesses trading at reasonable valuations outperformed the market in seven out of eight periods. Not only that, but these companies outperformed the market by an average of 5% per annum and delivered an average annual return of 12% - even in these inflationary periods. High quality businesses are those that earn high returns on invested capital and have wide profit margins. They tend to have strong competitive advantages which can afford them pricing power and an ability pass inflation through to customers more easily.
Other inflation hedges highlight that there are no free lunches
There are other asset classes that have a clearer link between inflation and investment outcomes than equities. Commercial property and inflation-linked bonds are often touted as helping hedge inflation. Many commercial property leases contain CPI escalators that allow inflation to be passed through to tenants. Likewise, inflation-linked bonds see their face value increase mechanically with inflation, providing a direct payoff if inflation spikes.
But these asset classes also show that hedging inflation isn’t without its costs or risks. Industrial property (which doesn’t face some of the reversionary value question-marks associated with retail and office property) is currently in high demand. Capitalisation rates are at all-time lows and valuations at all-time highs. Likewise inflation-linked bond investments require investors to accept low expected returns in exchange for this inflation protection.
There is no easy solution to the inflation conundrum. On one hand, equities may provide a good long-term hedge – but you need the risk tolerance and patience to stick out some volatility should inflation pick up materially. On the other hand, inflation-linked securities and property may provide more certainty around the inflation protections - but the low returns and high opportunity cost could be problematic, particularly if the current burst of inflation proves temporary.
As is often the case, balance is needed. Equity-oriented portfolios that are balanced with diversifiers like commercial property, inflation-linked bonds, infrastructure assets, and traditional fixed income continue to make sense. With the global economy at a fork in the road, there is value in not being overly aligned to one potential state of the world. Investors should try to preserve the flexibility to act when better opportunities again present themselves.