The Link between Inflation and Equity Returns

Several studies have indeed demonstrated that in the first stage of an inflationary cycle, equities perform relatively well because the first signs of inflation are often the consequence of an improving economic backdrop. There is a lag between a pick-up in inflation and the first monetary tightening. That period can last several months up to a year. In that period, equities are genuinely in a “sweet spot” as real bond yields become negative, hence reinforcing the TINA (There Is No Alternative) for equities. In the second phase however, equity returns decline as central bankers hike interest rates above nominal economic growth and inflation, leading to positive real interest rates. In that stage, equities lose their competitive edge over fixed income investments.

What can we conclude from these observations? In fact, one may conclude that a relatively benign inflation rate up to 4% is positive for equities. Beyond that level, equities tend to struggle. Also, we have seen that PE multiples (thus valuations) decrease in inflationary cycles. It is of paramount importance to look at the debt structure of companies, their pricing power, valuation and returns on tangible capital. It will become key to look for high-quality companies that are able to increase their prices beyond the inflation rate. Also, a complete absence of inflation or even deflation (the Japanese scenario) is very detrimental to corporate profits, but this is not our central scenario. Our general conclusion is that it is extremely hard to define hard and fast rules with respect to the link between inflation and equity returns. The response of individual companies will experience a very high dispersion and should therefore be taken into account in a bottom-up stock picking approach.

I have several links to comprehensive articles and research that analyse the impact of inflation on equities:

fb-share-icon
Tweet