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.