While many believe that with the output gap so wide that inflation is not an immediate threat, longer-term, as UBS notes, excessive money printing could indeed generate inflation and that inflation expectations are unusually volatile and could quickly be dislodged. This inflation hedges are a very valid concern. An oft-cited reason for owning stocks is that they have an implicit inflation hedge, however, just as with many market myths, UBS finds that, in fact, equities do not look like a compelling hedge against rising inflation.
Via Stephane Deo of UBS:
Indeed, they provide an appropriate hedge to rising inflation only in a limited number of cases.
- The trade has to be entered at a low level of inflation. If the trade is started above 4%, the valuation loss due to declining P/E will dominate and make equities underperform.
- If inflation increases only moderately. High-single-digit inflation would make the equity valuation loss dominate other effects.
- If the investor assumes that inflation will not decline. In that case, the trade would also generate sub-inflation returns. So an equity hedge comes with increased portfolio risk in cases of deflation. Here are our arguments.
If inflation surges, it is because companies are selling their goods at a higher price and, as earnings are a fraction of sales, surely earnings would move in tandem with inflation giving protection to investors. If the payout ratio is constant dividends would also mimic inflation even if some price distortions can obviously affect corporate margins. And indeed when we compute the ratio over the past century and a half between the US CPI and EBIT inflation (we remove the volume effects from EBIT), we find a decline by 0.02% per annum. This is low enough to be negligible. EBIT prices do move in tandem with inflation.
Unfortunately, the story is not that simple; if inflation is high and stable, the above argument makes sense. But the situation we are facing is the risk that inflation will jump from low to high levels. That has a very unpleasant consequence: a change in the discount factor and risk premium. On a DCF approach, the discount factor will go up, hence the accrual value of the future flows will not be multiplied by inflation, but by less. Higher inflation also means higher nominal volatility, hence higher risk premium, hence an even higher discount factor. So the P/E will adjust to take the new world into account. All prices have increased with inflation, except the price of the equities you have in your portfolio which has risen by less than inflation. You are not hedged.
Let’s go back to the real world. Our argument is that P/E or earning yields should move in tandem with inflation. We did investigate this issue in the past and actually found a very strong positive correlation between bond yield and equity earnings yield when bond yields are above 5%. But we find an equally strong correlation when yields are below 5%, only this time the relationship is negative. This is clearly visible in the two charts below.
From an economic point of view, this actually makes sense. Yields/inflation at a low level would signal that the economy is approaching a Japanese scenario, or is on the verge of deflation. Further decline in yields are negative for equity. By contrast, yields above 5% are associated with inflation rising to a level that becomes disruptive, with an associated increase in nominal volatility hence risk premium. The chart below shows a similar relationship with inflation: we find that 4% is the threshold, or the sweet spot, where equity prices are maximized.
This weakens the case for equities as an inflation hedge, because it means that, with inflation above 4%, equity valuations will start to play against us.
So let’s run the numbers, we start from the current inflation number, 2.2% in the USA. If inflation goes up, not only would equity return more because the nominal EBIT will follow inflation; but the valuation of equity improves as we approach the 4% magic number. In short, we have a hedge to inflation that returns more than needed. But if inflation increases above 4%, the valuation starts to deteriorate. We find that with inflation around 6.5% the valuation argument starts to bite so much that inflation protection starts to be eaten away and the equity return is less than inflation. The further inflation increases above this mark, the more equity valuation drops and the worse the inflation hedge becomes. We even find that with inflation around 9.5%, despite the increase in nominal EBIT, valuation destroys all the equity return.
Obviously, if inflation drops from where it is now, valuations deteriorate, hence equities underperform inflation as well.
In short, equities provide only a partial hedge – one which works only for small positive inflation shocks.
There is one additional point to keep in mind: the entry point of the trade is very important. Imagine that you wait for inflation to go to 3.5% before you get really worried and put on a long-equity trade with the view of protecting the portfolio against inflation. Because the position starts from a level much closer to the 4.0% sweet spot, the starting valuation position is much better, hence more demanding. It means that the negative valuation argument starts to bite much earlier. Indeed, if we update the above chart with a 3.5% starting point, the result is that protection disappears after just 5.0% inflation.
Conclusion: So, in short, an equity portfolio does not look like a compelling hedge. It works only for reasonably small shocks and if the trade has been entered early enough. It also increases the risk to the portfolio in case of deflation. The analysis, however, does not go into the breakdown by sector. A better sector approach, one which would overweight sectors with a low duration, would probably provide more supportive results. This is one interesting research avenue for the future. For now, the solution we propose is to create an inflation linked credit market.