Asking the wrong question on inflation

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Can’t go anywhere without seeing something about inflation these days. It’s all the rage. I think someone issued a new rule that every investing podcast interview has to end with at least one question on inflation. It’s the issue of the moment , if you can set aside memestocks and crypto for a second that is.

Inflation: here to stay or transitory ?

And look, I love a good debate about whether inflation is coming or not as much as the next guy (i summarised as many arguments for and against as I could in 1,000 words back in March – think this still stands up) . A few things have changed since then. The reopening has gathered pace , we’re seeing spot shortages of some things , there’s been more than a fair share of egregious chart crimes showing eye watering inflation levels over the last 12 months – but of course a lot of that is driven by exaggerated low base effects from last year.

Debating inflation is practically sport , I get it. Talking heads can say incredibly smart things like “regime shift”, “inflection point”, “Phillips curve”. The hawks who’ve wrongly warned of inflation for the last decade have their time to shine and get all excited. Day to day markets seem to be extraordinarily sensitive to central banks and expectations of their activities.

But it’s just the wrong question for investors. The more helpful framework for investors to think about inflation isn’t simply high / low it’s rising / falling , and expected vs unexpected.

Secondly , crucially , investors need to think about assets and hedging vs outperforming.

1. High / low vs rising / falling

Some of the traditional wisdom on the relationship between stocks and inflation is sketchy, to say the least. You often hear people saying that stocks are a hedge for inflation (spolier: they aren’t). But right now the fear is more the opposite – that sky high market valuations could be punctured by a sudden rise in inflation that forced an interest rate hike or two.

Here’s the data from the credit Suisse yearbook : equities hate the very highest levels of inflation , other than that there ‘s no strong relationship , they do ok in most inflation environments (although they love the lowest inflation environments).

This lack of a clear relationship makes sense when you unpack some of the complexity. Inflation could push any of revenues, costs and discount rates up or down , exerting opposing push / pull influences on prices. It naturally varies by sector too. And of course companies are very dynamic things too, they will respond, adjustments can be made , they might suffer an initial shock but reposition to benefit. It depends how they adjust to new inflation expectations.

So at the overall level all we see is the equity risk premium chugging along above it all, other than in the most extreme environments.

A better way to understand this conceptually is – like many thing in investing – in terms of expectations.

A certain expectation of inflation gets built into prices of assets – both bonds and equities. We can observe this from the bond markets, but the same expectations get built into the discount rates used to price equities (great explainer from Aswath Damadoran here ).

If inflation pans out higher than expected this is generally bad for assets as investors incorporate this into their valuations, increase the discount rate applied, hence lowering the price. If inflation is lower than expected the opposite happens – which has been the case for the last decade.

Note the expectations could be high or low , the key point is whether the outcome was higher or lower than that (and also how the new expectations a adjusted for the outcome) not simply whether inflation was high or low in absolute terms.

To complicate matters. Schroder’s found that equities actually have a good record of outperforming bonds when inflation is low and rising compared to when it’s high and rising , so both level and direction potentially matter.

This is supported by work from AQR who show that there’s a reversal of fortunes looking over different time periods – since 1997 (when inflation has been low) stocks have done well in rising inflationary environments, whereas over the whole period stocks are negatively impacted by rising inflation.

This still leaves us with many different ways things could go from here. both actual and expected inflation is low but not zero, so we can’t rule out unexpected rising or falling (from a low base ) or indeed stability at a low level. Most of these scenarios are probably positive to neutral for stocks, given the data we have, but sharp inflation upside surprises is the one to worry about.

A word on the data

The three best long term independent datasets around are the Credit Suisse yearbook, Ibbotson Stocks, Bonds, Bills and Inflation ((SBBI), and the rate of return on everything paper.

But there’s a problem: there’s a definite risk of over-squeezing limited data here. Even with c100 years of data it’s not like we have a full database that comes close to covering every asset and inflation regime. Ideally what we want to see significant datasets of asset performance for rising and falling inflation from high and low levels. With high expectations and low expectations, from high and low equity market valuations, inflation due to supply shocks and demand driven rallies. Pre and post central bank independence, with and without the presence of QE. At best there’s a handful of inflation regimes in even the longest datasets , they don’t cover anywhere near the combinations you need to take a strong data-driven view, and you only get the data for the most basic asset classes.

There’s an illusion of data here, but really the initial conditions are so different all bets are off.

Assets – Hedging vs outperforming

This is where a lot of commentaries get a little careless. The idealised inflation asset is sometimes presented as one whose returns match rises and falls in inflation AND delivers a positive risk premium itself. But this asset doesn’t really exist , not today anyway with the real yields on most bonds low or negative. So you have to wrestle with trade offs

The alternative is an asset – like stocks – that is likely to grow in excess of inflation over most periods , but won’t match all the rises and falls. There are also some in-between assets that have some inflation related drivers , that might co-move with inflation , but can’t really be called hedges like property and infrastructure.

And before you can say G-O-L-D let me stop you there. Gold is not really a hedge for inflation in any meaningful way. This piece does a thorough job of working the arguments through. Crunching numbers through a strict mathematical lens can show inflation sensitivity, but a quick look at the long run price series shows you what the issue is. Plenty of inflation in the 80’s and 90’s eating away at your portfolio while gold was busy losing 60% of its value. Gold might be a hedge for stories about inflation, and in some fleeting situations it’s helped, depending on start and end points you can make it look additive to portfolios, but it’s correlation to inflation is variable and frequently negative.

In conclusion – complex problem simple answer

Inflation does matter for investors, and it’s fun but very hard to speculate on it. But that’s the wrong question. Even taking a more realistic model of rising / falling inflation expectations doesn’t make things any easier , there’s still a lot of moving parts.

I see 4 distinct actionable takeaways for investors –

1. Equities: go global, including emerging, don’t hedge currency. Ultimately we can complicate the questions all we like but we get back to a simple – if unsatisfying – conclusion – broadly diversified global equities do well in real terms over long periods in most all conditions. Investors shouldn’t be in the business of looking for and paying for hedges for every conceivable risk (or even any risk) , it’s just not a good long -term strategy .

Stocks aren’t an inflation hedge, but they are your best bet for real returns in pretty much any environment. Even more so when real returns on bonds are so low , equity investors shouldn’t fear inflation.

Global equities are good for diversification but also because high inflation in any one country is likely to lead to a weaker local currency and better performance from foreign equities (the Credit Suisse data backs this up). This is particularly the case for small developed markets like the UK or Canada but also holds for the US.

I reckon you definitely want emerging markets in there too – if we’re facing the roaring 20’s with huge demand for devices and chips , you want to make sure you’ve got exposure to those couple of companies that produce >85% of chips (read more here).

2. Hedges . With real yields so low investors face a worse trade off than usual when looking at direct inflation hedges like inflation linked bonds . These match inflation by design but with zero or negative real yields you can’t justify much allocation in a growth portfolio, especially after fees.

If you do hold some government bonds there’s a case for tilting toward inflation protected over fixed rate if you’re worried about inflation.

3. Real growth assets like property and infrastructure certainly have a good inflation story to them and also stand up on their own as growth assets based on long term return, although property has its own challenges right now. You can access these in unlisted or listed form (eg REITs). Of course you pick up some exposure to these in your global equities , you might also want to tilt a little further with a dedicated allocation. These assets are also good for levering on favourable terms which if you’re thinking of inflation is also not the worst idea in your portfolio in small amounts (some funds and investment trusts will build in leverage).

Commodities don’t have evidence that supports a long term risk premium , so for me these can’t be justified beyond small allocations , and even then does it really matter ? Your 5% allocation would basically need to double to make an impact on your overall portfolio.

4. Short dated bonds – not a hedge at all but in a rising inflation environnement you expect interest rates to rise , and new (higher) inflation expectations get built into newly issued bonds. In this world shorter dated and floating rate bonds (eg asset backed securities) ought to do better than longer dated and are less vulnerable to sharp shocks in inflation expectations.


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