Inflation and Stock Prices
Inflation in the developed and the emerging world is rising. At the same time the 12-month-forward price/earnings ratio on the S&P 500® currently stands at a near 14-year low, reflecting in part increasing uncertainty about the future path of inflation and corporate earnings.
This article briefly examines the relationship between inflation and stock prices. We make several observations:
1. There are multiple definitions of inflation, making it difficult to measure.
2. It is useful for investors to distinguish between the absolute level of inflation, the trend of inflation, inflation uncertainty, and inflation volatility. In many cases, the acceleration of inflation is associated with rising inflation uncertainty.
3. Another useful distinction is between anticipated inflation and unanticipated inflation. Historically in the United States, both a high level of anticipated inflation (over 5% per annum) and increasing inflation uncertainty have been associated with declining price/earnings ratios.
4. Stocks appear to be an imperfect inflation hedge in the short and medium term, and are much better hedges in the long term than the short term.
5. In theory stocks should be inflation neutral, with only unanticipated inflation negatively impacting stock prices. However, for stocks to be inflation neutral, companies must be able to pass on cost increases, and future nominal free cash flows must be equal to real cash flows multiplied by the inflation rate. As well, investors must discount those cash flows at the same real interest rate used before the onset of inflation.
6. Empirically, in the US, price-earnings ratios tend to fall when inflation accelerates, a phenomenon that has puzzled finance academics. There is vast academic literature on inflation and stock prices and multiple theories as to why price-earnings ratios fall when inflation rises.
David Fuller's view The biggest risk for equities from rising inflationary expectations is higher short-term and also long-term interest rates. Short-term interest rates would go up because central banks tighten monetary conditions to combat inflation. Long-term rates rise because bond investors demand higher yields to maintain a real (inflation-adjusted) rate of return commensurate with risk.
Companies have proved adept at adjusting to difficult economic conditions over the last two years, mainly by slashing overheads, but inflation distorts the normal business practices in a number of ways and affects some corporate sectors much more than others.
For instance, manufacturers are among the first hit as the cost of energy, metals and other industrial commodities rises. They may switch from just-in-time purchases to stockpiling resources, which exacerbates the rise in commodity prices. Also, they cannot be sure of passing on increased costs to their customers, who may reduce orders. The net result is increased overheads and less revenue.
Wage inflation, which we are unlikely to see in OECD countries anytime soon, is particularly destructive for companies with large labour forces. Unions will counter any effort to prevent inflation-adjusted salary increases with demands for earlier retirement and expensive pension and other entitlement schemes. This helped to undermine the US automobile industry in the 1970s and 1980s, and is a major contributor to Greece's deficit crisis today.
Commodity producing companies are among the beneficiaries of inflation, at least until recession sets in. Similarly, utilities have some protection against inflation because they can pass price increases onto customers. Asset-rich companies may benefit, not least if land prices are revalued upwards.
Overall, companies may be tempted to engage in more speculative activities to counter the negative effects of inflation or to profit from upward pressure on prices. This may not be in their best interests. My observation has been that equities often benefit in the earlier stages of an inflationary cycle but suffer in its latter phases.