On top of the fifth wave due to omicron, the main current world concern is about inflation, and especially how this may affect economies and financial markets, e.g. stock prices.
On the later, recent FED readings as to how it might aggressively raise interest rates have led to a significant downward pressure on stock price in the US first ,then worldwide, with a especially large pressure effect on technology stocks, which traditionally have higher duration than the average market.
TWO QUESTIONS AND THEIR ANSWER
Still, while the inflation boost can’t be neglected, it is crucial to have a few questions answered. First, what is the evidence that this will be large and sustained (Q1) . Second, what is the evidence that this can affect product and financial markets (Q2) . On Q2, for example, one learns from conventional financial theory that equities should compensate for inflation since they represent claims against real rather than nominal assets.
But, here are a few thoughts regarding the possible answers to both questions:
Q1: Lasting inflation, or not?
The recent months have witnessed a re-emergence on general price increase. At current, the consensus is that general price increase may be sufficiently large and non-transitory, especially after the FED has warned of both stopping quantitative easing and increasing interest rates rather quickly. This move by the FED may rely on the belief that recent raw materials supply chain tensions may persist, while on the workers side, wage inflation may start to build as a result of tight labor supply, — leading possibly to a risk of wage -spiral effects. Against the FED argument, there are also economic voices mentioning that large deflationary effects are in the making. Automation may be a way to solve for labor market tightness, which may lead to worker substitution and lower wage power; digitization has been largely deflationary in recent years and will continue along the digitization maturity of economies.
Thus, the story of sustained inflation is not necessarily warranted—in effect, if the US long-term interest rate shows some increase recently, the yield curve is not that very steep, and is still lagging the rates seen before covid-19 hit the world.
Q2: How does Inflation link with stock returns?
On a macroeconomic level, only money illusion would imply that inflation would affect stock returns, through its differentiated effect on real interest rates and corporate cash flows.
On a microeconomic basis, though, inflation beta may be more or less than one to one, depending on how companies can adjust along how inflation affects real economic activity, and how firms with strong market power may be able to better pass through inflation into higher end user price and thus build new profits. This means that: weak firms facing elastic demand and output pressure may thus put their equity value at risk from increased inflation. The reverse is however true, which implies that inflation may thus profit stronger firms.
Net, net thus, inflation may adversely weight on stock returns, to the extent that a) equity duration is high, b) money illusion reigns, c) firms face poor price pass-through power; d) increased real interest rate reduces economic activity. Those effects, as we argued above, are not necessarily systematic, and may vary across firms, sectors and countries.
Besides theory, one can also look how inflation has empirically played in the past.
Macro-view. Early macroeconomic evidence had suggested that stocks may not necessarily fully immunized from inflation. Still, the results were neither pervasive, nor especially robust from the econometric perspective, as early studies did not account from the fact that series like stock returns may not be stationary.
A more accurate test, in such a case, would then be to look at the evidence of a structural, so -called, cointegration relationship between levels of inflation, real interest rates, stock returns and economic activity. If any such relationship is found, this would mean that this relationship is sustained, and any short-term change will be associated to dynamic deviation to this structural relationship. The most recent body academic research, -and our own test on the G-7 countries over the last 15 years-, confirm cointegration, with three insights:
1. Economic activity has typically a positive relation with stock indices, — and in most cases for inflation
2. Real interest rates depress stock prices.
3. In the short-run, inflation and deviate from long-term and exert a negative pressure on stock return indices
The above results thus suggest in the long-term, ( read- about 3 years horizon ) that there is some “good money illusion”, e.g. stocks are in effect, for the most part, a strong hedge against price increase. Still, in the short-term, inflation puts downward pressure on stock indices, as a possible signal of increase in real interest rates and lower economic output.
Thus, the key is to distinguish short-term versus long-term to see how stock markets will react- but in general, inflation boost starts with a repricing downwards and adjust accordingly to long-run afterwards, meaning that time horizon matters for how inflation affects financial market returns.
Microview. The same pattern prevails between short and longer term for individual stock, even if some companies delver better than others. In general, the structurally most inflation-hedging stocks seem to be in Health Care, Energy, Industrials and Technology.
WHAT TO CONCLUDE?
The conclusions one can derive from the above is thus three-fold.
A) Importance of time horizon. Inflation may be a stock return friend or not, depending on time horizon on holding stock; in general, long-term holding leads to great hedging, — but this may be challenging short-term.
B) Not every stock is a good hedge. It depends on duration, and ability to passthrough inflation in better user price to boost cash flow. Technology stocks may face pressure due to their high duration, but may recover from market power ability, for example
C) Negative real interest rate remains a good news. The last one conclusion to note is that inflation may seem high now, but nominal interest rates remain very low, with 10 years’ US rate is still less than 2% nominal—with rising inflation, real interest rate are negative, pushing in favor of allocation towards stocks. After all, not everything is that bad for stocks, despite the recent turmoil.
© jacques bughin