Inflation and all its shades are not good for equity returns

Equities 7 minutes to read
Peter Garnry

Head of Equity Strategy

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.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zürich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed here or within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.