Do equities protect against inflation?

international equities australian equities equity markets

31 January 2013
| By Staff |
image
image
expand image

Dr Stephen Nash uses both domestic and international data to argue that equities will not protect investment portfolios if there is a spike in inflation.

Often investors operate under the impression that there is a link between the consumer price index (CPI) and equity returns.

This article uses both Australian and US data to show there is in fact a negative correlation between the two.

Historic inflation

Underlying inflation has been contained within the annual Reserve Bank of Australia (RBA) target band of between 2-3 per cent in recent years, especially since 1993.

However, in the past there have been inflation spikes. Beginning in 1974 through to 1977, annual inflation was over 10 per cent and reached a peak in the March 1974 quarter of 17.6 per cent.

In the period from 1980 to 1984, inflation again hovered near or over 10 per cent (see Graph 1).

One of the major threats to purchasing power is inflation, and while the RBA may control underlying inflation, headline inflation can still be quite elevated, which damages purchasing power.

The need to hedge, or insure, against inflation is particularly important for those investors at or near retirement who are dependent on their savings to live. Importantly, the only direct hedge or insurance against (and thus protection from) inflation are inflation-linked bonds.

Australian CPI – looking forward 

If you thought that worrying about inflation was “old hat”, then think again.

As Graph 1 indicates, while headline inflation has moderated of late, it is still a significant force that erodes investment principal and interest and needs careful consideration when setting investment asset allocation.

Recently, the headline CPI was impacted by the carbon price. It is expected to be over 3 per cent by June 2013, according to the RBA in the November Statement on Monetary Policy, at a time when the prospects for growth are questionable.

If tensions erupt in the Middle East, then an oil price of US 150 (WTI) could wipe out growth as quickly as it raises headline inflation, leaving nominal rates lower and headline inflation more towards 4 per cent.

The CPI measures quarterly changes in the price of a 'basket' of goods and services which account for a high proportion of expenditure by the CPI population group; that is metropolitan households.

This 'basket' covers a wide range of goods and services, arranged in eleven groups. 

Hope of link between the CPI and equity prices

As this CPI basket measures output prices from the broad economy, you might expect that it would rise and fall, based on the presence or absence of supply constraints throughout the economy.

So, if the economy is doing well, then supply constraints will increase, which will boost the CPI.

Similarly, at the same time when the economy is doing well, equity prices would also rise.

This would imply that as the CPI rises, so too would equity prices, meaning that equity returns provide insurance against inflation.

Also, the opposite would also be the case, so that when supply exceeds demand, and the CPI falls, so too would equity prices fall.

Hence, you would expect a fairly high correlation between the CPI and equity prices. More specifically, correlation can be described as follows:

Correlation is a statistical technique that measures the extent to which two variables move together, or move in the opposite direction, over a time series.

Large positive correlations indicate that two variables are moving together strongly over time, and large negative correlations indicate that two variables are moving strongly in opposite directions.

However, the general observation does not support a strong positive correlation, between equity returns and the CPI in the short or the medium term.

One of the main reasons the relationship does not hold is that equity returns represent expectations of future earnings, so that equity prices reflect the sum of expected return over the forthcoming investment horizon. Notice the use of the word ‘expected’.

Equity prices reflect not the actual earnings in the forthcoming period, as they are unknown at the point of forecast, but expectations of those earnings.

Since expectations are notoriously volatile, the annual return of equities just reflects the underlying volatility of earnings expectations, and this volatility has little, or anything, to do with variations in the level of the CPI. 

In order to verify the reality of volatile expectations, we plot a time series of the annual CPI with annual return from Australian equities in Graph 2, where we use the total return from the All Ordinaries Accumulation Index.

Notice how the two series move in different ways, and how volatile equity returns remain, relative to the CPI. 

We can take the analysis a little further by doing a rolling 20-period correlation, between the annual CPI and annual equity returns, which is a rolling five-year analysis, given that the CPI is released quarterly.

In Graph 3 we plot the results of this analysis and we see that the two series are quite negatively correlated; annual CPI and annual equity returns.

Longer-term US data

For those who think the data is limited in the above study, we refer to longer-term data from the United States (see Graph 4).

Similar results are evident, as in the case of Australia, where equity returns and the CPI move in different directions.

Even if we average annual returns for rolling five-year periods, and we also average the CPI for the same period, the relationship still is one where the two series tend to move in opposite directions over time (see Graph 5).

We must agree with others in the field that there is little evidence of a short- or medium-term relationship between equity returns and the CPI.

A tentative relationship emerges over the very long term – a period that is beyond the investment horizon of most investors. As Deutsche Bank recently concluded: 

“To sum up – if there is any relationship to reveal at all, it appears that inflation and equity returns are actually marginally negatively correlated.

This should not be particularly surprising, given the poor performance of equity markets during the inflationary 1970s, and subsequent strong performance since inflation has trended lower.”

Forthcoming expectations for equities 

As we have said for several months, the equity market faces significant problems mainly because the equity market built up expectations of growth from the long anticipated easing from the Federal Reserve, known as QE3.

Here, the equity market built in general economic growth for the US of over 3 per cent for an extended period. Now, the equity market needs to come back to a more realistic estimate of forward earnings as it overcomes the following:

  • disappointing earnings
  • a possibly large fiscal contraction
  • further credit rating agency downgrades of European sovereign issuers and corporate issuers
  • further credit problems in the European banking system
  • further disruptions from the European economy, and the prospect of a large European recession in 2013, and
  • possible credit rating agency downgrades of the US government

Given that equities do not insure against inflation in the short or medium term, the need to obtain a direct form of insurance, through inflation-linked bonds, looms large.

Dr Stephen Nash is the director of strategy and market development at FIIG.

Read more about:

AUTHOR

Recommended for you

sub-bgsidebar subscription

Never miss the latest news and developments in wealth management industry

MARKET INSIGHTS

Completely agree Peter. The definition of 'significant change is circumstances relevant to the scope of the advice' is s...

4 weeks ago

This verdict highlights something deeply wrong and rotten at the heart of the FSCP. We are witnessing a heavy-handed, op...

1 month ago

Interesting. Would be good to know the details of the StrategyOne deal....

1 month 1 week ago

Insignia Financial has confirmed it is considering a preliminary non-binding proposal received from a US private equity giant to acquire the firm. ...

1 week 5 days ago

Six of the seven listed financial advice licensees have reported positive share price growth in 2024, with AMP and Insignia successfully reversing earlier losses. ...

1 week 1 day ago

Specialist wealth platform provider Mason Stevens has become the latest target of an acquisition as it enters a binding agreement with a leading Sydney-based private equi...

1 week ago