Concerns about inflation have taken centre stage for investors this year following unprecedented levels of government stimulus, especially in the light of the recent US inflation prints. In this paper, we do not take a view on whether inflation will hold. Instead we examine the historical trends for equities associated with the rise in interest rates and inflation.
Notions of how inflation affects equities are many and varied. On the one hand, equities provide investors with exposure to ‘real assets’. On the other hand, it is hard for companies to keep up with the hidden costs of inflation. Remember the ‘investor misery index’, i.e. the inflation rate plus the ratio of capital that must be paid to transfer annual earnings delivered by companies into your own pocket when inflation is running high (see 1979 Berkshire Hathaway shareholder letter). The conclusion of Mr Buffett was that high inflation rates rarely translate into higher real rates of return.
Through our own bottom up analysis we arrive at four conclusions:
- The underlying cause of the rise in interest rates must be properly understood in order to understand its effect on equities. If the driver is higher growth expectations, this should be broadly positive for equity markets (especially at the cyclical end), whereas sustained (i.e. multiyear, rather than one-off) rising inflation expectations should have a more mixed effect, depending on company type. Companies with strong cash returns (a measure of competitive advantage) tend to do better than peers in a rising inflation environment. There is also strong empirical evidence that value performs better in an environment where bond yields are rising.
- Within the equity asset class, the effects of rising rates and inflation can vary. Received wisdom has it that growth-orientated sectors tend to be long duration, so should be much more affected by rising rates. In reality, we find that the dispersion in equity duration across sectors is not as wide as commonly perceived. We therefore favour a more bottom-up approach.
- In an inflationary environment, headline earnings can be even more misleading than usual. When inflation is rising, reported earnings push up nominal return on equity, which brings the price-earnings ratio down, creating the illusion that a stock is cheap. In fact, all nominal measures can become potentially dangerous during inflationary periods.
- Inflation has no direct effect on the equity risk premium, but higher levels of inflation are normally associated with greater uncertainty, and that can push up the risk premium. This high risk premium illusion emerges because inflation often results in a de-rating of traditional value stocks; traditional accounting measures become more misleading as rising inflation drives a wedge between reported and cash earnings. It takes a prolonged phase of declining inflation to make value less attractive relative to growth stocks. Higher interest rates significantly impact debt serviceability within global equities