The Big Read: 105 years of US inflation and equity returns

While inflation has been positive as long as states have existed as it stems from a complex interaction between fiscal and monetary policies and technological developments, we have seen periods of deflation. Post World War I consumer prices declined rapidly during 1920-1922 before settling for a long calm period leading up to the Wall Street Crash of 1929. As financial markets imploded and credit markets froze, consumer prices plunged 27%, the most on record, in period 1929-1933. There were only two brief periods afterwards in which deflation showed its face and these occurred just after World War II in 1949-1950 and during the Great Financial Crisis in 2008-2009.

Warren Buffett wrote extensively about equity returns and inflation in his shareholder letters during the 1970s. He calls it the inflation tax as it consumes capital and increases the threshold for businesses to deliver a real rate of return on capital. When inflation is high, earnings and growth become less important than inflation and even companies with a strong businesses can find it almost impossible to deliver a positive real return on capital. As the chart below shows, inflation drives a wedge between nominal returns and real returns with the latter being the only thing that matters from a wealth perspective. To see the “inflation consumes capital effect”, look how US equities in real terms peaked in April 1969 and declined during high inflation until July 1982. That’s a 13-year period of negative real return for equity investors. Most investors forget the inflation tax and let their sentiment run with nominal returns. US equities did not make new highs in real terms until 1995.

Because higher inflation significantly increases the hurdle rate (or minimum required rate of return) for businesses, investors should avoid any low margin businesses during inflationary times as these companies will not be able to defend the purchasing power of the capital employed. Another piece of advice that Warren Buffett provides is to invest in businesses that are able to raise prices and offload the inflation tax to consumers. This is probably where Charlie Munger managed to convince Warren Buffett to embrace companies with strong consumer brands and higher valuations over businesses with low valuations and no consumer brands.

The inflation tax and its impact on capital also help explain why P/E ratios on US stocks reached an all-time-low in 1982. Why would investors pay high prices for assets not delivering a return over inflation? As we will see in the data, the inflation rate is tricky for equities and their investors. One has to distinguish between short-term and long-term effects of inflation.

Inflation rate and the inflation surprise

Our analysis of inflation and equity returns is based on 105 years of data. We created two inflation time series: 1) the 1-year inflation rate and 2) the inflation surprise which is the difference in the 1-year inflation rate and the 3-year average of the 1-year inflation rate. The hypothesis about our inflation surprise measure is that the average recent inflation rate drives the inflation expectations for the medium term. All inflation data points were grouped into deciles and monthly equity returns (nominal and real) were grouped accordingly. As there is a lag between inflation data and the monthly equity returns this study is a descriptive statistical analysis.

What we observe on equity returns against the inflation rate is not that surprising given the points about the inflation tax. The higher the inflation rate the lower the nominal and real equity returns are. The “magic threshold” seems to be around 3% inflation rate based on historical data. Beyond this point inflation begins to consume capital disproportionately, making it difficult for businesses to operate and investors to make real returns. There is a small “valley” in the first three deciles but this is most likely statistical random noise in the data. The more meaningful and broader interpretation is that high inflation about 3% is bad and any inflation level below this level has produced good equity returns in nominal and real terms.

What makes the inflation analysis far more interesting is when we turn to the inflation surprise. Here we generally observe a positive slope across the deciles with a negative inflation surprise being very negative for equity returns and a positive inflation surprise being positive. How does this link to the opposite relationship we observed between equity returns and the 1-year inflation rate?

Our hypothesis is that in the short term any significant downside surprise in inflation is linked to a bad economy, credit contraction and financial market stress and is thus linked to negative equity returns. A positive inflation surprise on the other happens in the short term on the backdrop of an economy running hot, which if we exclude exogenous shocks from commodities such as oil, is likely correlated positively to high profit growth rates for companies.

The initial positive inflation surprise is likely to cause an initial rotation of capital out of fixed income securities as those fixed returns will be eaten up by the inflation tax and companies offer some inflation protection in the short-term through the price setting mechanism. However, if inflation remains high above 3% regardless of an initial positive inflation surprise and continues to go higher, the hurdle rate likely goes beyond what is feasible within setting consumer prices and then the capital destruction process sets in and equity returns become negative in both nominal and real terms.

It is therefore important for investors to recognise that while rising inflation can be bad, a positive inflation surprise has generally been positive for equity returns. Only if inflation goes above 3% and stays there does the investment decision on equities need to change.

The inflation smile

Instead of focusing on monthly equity returns we also extended our study to monthly return volatility across the 10 inflation regimes. Here we see a clear picture between equity volatility and the 1-year inflation rate. During high and low inflation periods equity returns tend to be more volatile than during more subdued period of inflation with the high deflationary periods being extremely toxic and feeding into equity volatility. It looks as if inflation drives a volatility smile in equity returns.

Could the ghost of inflation return?

For 37 years financial markets and the world have been trapped in the Great Moderation as low volatility in financial markets is often a sign that hidden risks are building up under the surface. The same goes for inflation. Economists do not fully understand the concept and the inflation dynamics can be violent to the upside and downside beyond certain stressor points. As we have grown used to low inflation many investors are most likely very complacent about it and will not be not prepared should it arrive. Inflation or deflation of a more extreme nature is likely to make a reappearance, although the timing can be difficult to predict. But what are the catalysts that could drive inflation much higher from today’s level?