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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Head of Fixed Income Strategy
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Inflation and all its shades are not good for equity returns
Peter Garnry
Chief Investment Strategist
Summary: In today's equity note we focus on inflation and the different ways one can define inflationary and deflationary periods, and how equity returns are impacted during these two regimes. While nominal returns are less affected, the real returns on equities are drastically impacted by inflationary periods. In general, we observe favourable equity returns during deflationary periods (those with either low inflation rate y/y or declining CPI m/m) and vice versa. These observations are important for investors today, and especially growth investors that are basing their expectations on a goldilocks period over the past 10 years.
Back in 2019, we wrote a big read on US inflation and equity return, and we have referred back to this many times to give people the proper background. With inflation expectations rising and record stimulus being thrown at the economy to get back to full employment, it worth looking at this one time, but also because with higher inflation comes higher interest rates. The latter has recently caused havoc in technology and bubble stocks as we have written extensively about, see here and here.
In today’s equity update we focus on US inflation and equity return in the period since 1969. For this period, we have total return indices available, which gives a more accurate picture of inflation and equity returns, but also covers the current free floating fiat currency system we have in the world. There are many ways that we can define inflation and deflation to gauge the impact on equity returns. Normally deflation is defined as outright falling prices, but in today’s exercise we define differently. Since 1969 the median yearly inflation rate in the US has been 3.1% and we thus define an inflationary period as a period with yearly inflation above 3.1% and a deflationary period as one with lower yearly inflation.
The chart below shows the cumulative log returns for US equities for the two periods. What is striking is the stark difference in cumulative equity returns between inflationary and deflationary periods. In nominal returns the difference is quite big, but the overwhelming inflationary period from 1969 to 1991 did deliver positive equity returns. But the key difference arises when we transform the nominal equity returns into real returns (inflation subtracted). The difference in log returns explodes on real returns between inflationary and deflationary periods. This crystalizes why equity investors fear inflation and why Warren Buffett called it the worst tax of them all.
One might argue by focusing on the median inflationary rate as the cut off point, we naturally compare two very different periods in time, and with vastly different equity market compositions in terms of companies (industrials vs digital). That is a fair critique, but on the other hand, this is the only data we have available to give some sort of prior to base our investment outlook on.
If we change the inflationary and deflationary definition to that of rising and falling US CPI Index m/m then we get a different picture, but the overall conclusion is the same. Inflationary environments are worse for equity real returns over the entire period, but a little less so since 1998. This could indicate that the inflationary pressures we have experienced over the last two decades have mostly originated from lower general inflation rate but also demand driven instead of the cost-push inflation of the 1970s driven by higher energy prices and rising nominal wages as labour unions had a stronger hand compared to the previous decades.
As we wrote in our equity note on Friday, the reason why equities respond negatively to interest rates is because it pushes up the cost of capital. Some of it is offset by rising growth expectations as rising interest rates do have a link to rising growth expectations. The overall impact is negative from rising interest rates and if inflation accelerates and stays above 3% for an extended time the overall effect on equity returns get increasingly worse. As a result, investors today do have to think hard about how the equity portfolio stands against inflation and how sensitive the portfolio is to rising interest rates. Back in early January, we published our commodity sector basket which does possess inflation hedging capabilities as real physical prices tend to go up during inflationary periods.
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