What is the link between inflation and equity returns?

IN PLACES WHERE it has been long absent, it is hard to remember what a curse inflation is. In other places, it is hard to forget it. Take Zimbabwe. In 2008 it suffered an inflation rate in the squillions. Prices doubled every few weeks, then every few days. Banknotes were so much confetti. Some people turned to equities as a store of value. A share purchased on Monday might be sold on Friday. Harare’s stock exchange was almost like a cash machine.

In principle, equities are a good hedge against inflation. Business revenues should track consumer prices; and shares are claims on that revenue. In some cases, they may be the only available hedge. Iran, for instance, has had one of the better performing stockmarkets, because locals have sought protection from inflation. Sanctions make it dangerous to keep money offshore.

Rich-country investors have a different sort of headache. Though the immediate outlook is for inflation to stay low, it could plausibly pick up later on. If it does, edge cases like Zimbabwe or Iran are a bad guide. The link between inflation and equity returns is not straightforward. Stocks are a decent inflation hedge in the long run. But over shorter horizons, there is an inverse relationship. Rising inflation is associated with falling stock prices, and vice versa.

Start with the evidence that stocks beat inflation over the long haul. In the most recent Credit Suisse global investment returns yearbook, a long-running survey, Elroy Dimson, Paul Marsh and Mike Staunton show that global equities have returned an average 5.2% a year above inflation since 1900. You may quibble that the survey covers the sorts of stable places that have had a long run of stock prices in the first place, such as Britain and America. Even so, the finding fits with intuition. When you buy the equity market, you buy a cross-section of a country’s real assets.

Yet stock investors still need to be mindful of inflation. Markets tend to put a lower value on a stream of cash flows when inflation rises; and a higher price on cash flows when it falls. There are competing theories for the inverse relationship; many date from the late 1970s and early 1980s. A paper written by Franco Modigliani and Richard Cohn in 1979 put it down to “money illusion”: rising inflation leads to falling stock prices because investors discount future earnings by reference to higher nominal bond yields. The correct discount factor is a real yield (ie, excluding compensation for expected inflation). Other theories said that inflation is merely a reflection of deeper forces that hurt stock prices: an overheating economy; rising uncertainty; political instability.

In the decades since then, inflation has steadily declined. Stocks have re-rated. Investors have been willing to pay an ever-higher price for a given stream of future earnings. You might put this down to the Modigliani-Cohn effect in reverse, since nominal bond yields have also fallen. But so too have long-term real bond yields. The real rate of interest needed to keep inflation stable is lower.

Now for the headache. For the most part, financial markets reflect the view that inflation will remain low. Nominal bond yields are negative in much of Europe and barely positive in America. In stockmarkets, there has for a while been a sharp divide. Companies that do well in disinflationary environments (technology, branded goods) are expensive; businesses that might do better in inflationary ones (commodities, real-estate and banking) have generally lagged behind. The immediate prospect is indeed for an excess of supply. The unemployment rate in America is close to 15%. Inflation is already falling.

Further out, though, the outlook for inflation is murkier. There is no shortage of pundits who say it is primed to pick up. They have a case.

Globalisation, a key reason for the secular decline in inflation, is reversing. Big companies are likely to emerge from the crisis with more pricing power. The rise of populism in rich countries is hard to square with endlessly low inflation. Fiscal stimulus is in favour. The more government debt piles up, the greater the temptation to try to inflate it away.

For all such speculation, it is far from clear whether, how fast and by how much inflation might rise. A modest pickup might even be good for stock prices—especially in Europe, where bourses are tilted towards the cyclical stocks most hurt by unduly low inflation. But it is foolish to believe that inflation will leave your stock portfolio unharmed—and too easy to forget the damage it can do.