Author: Ivanhoff

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:

Stock Market or Market of Stocks

Over the past several years the money that has gone into ETFs has significantly increased. As a result the correlation between stocks from one sector and between stocks in general has ticked up. We live in market environment, where the impact of beta grows stronger, especially during corrections.

We like to think that it is a market of stocks and not a stock market; that equity selection matters. It actually does, but mainly on the way up and when earnings growth is scarce. In the era of ETFs, baskets of stocks are getting bought and sold simultaneously and often the weak rise with the strong and the strong fall with the weak.

Yes, of course if matters if a company grows its earnings by 200% y/y and its sales by 60% y/y. Eventually rising expectations for higher earnings will result in buying and price appreciation. Keep in mind that when the stock market declines, emotions rule decision making and all rationality is thrown out of the window. If you are an investor and the reason you bought still exists, the day to day volatility is just noise that needs to be ignored and corrections should be even welcomed as opportunities to add to a position. The question is, are you an investor or are you a trader and what is your time frame of market engagement? If you consider yourself a trader, price action should be your leading indicator and loss minimizing stops  need to be diligently honored in order to survive and prosper. Remember, there is one basic rule in the capital market jungle – fight only battles that you can win.

The Importance of Liquid Secondary Markets

Higher liquidity leads to a decline in transaction costs (bid/ask spread + commissions) and therefore: a decrease in risk premium. If you are able  to sell your assets quickly at the current market price, the perceived risk is lower – not only for you as an investor, but also for your creditors. Liquid secondary markets cause a decline in risk premium, which by definition leads to an  increase in the value of the traded financial assets.

The existence of liquid secondary markets is essential condition for developed IPO markets. Secondary markets are the main exit strategy for IPO investors, therefore the higher the liquidity the higher the interest in IPOs.

IPOs are an effective tool for venture capitalists and entrepreneurs to transfer part of the risk to the public; to get paid for their work or simply to raise more capital for further expansion. In the same time investors (the public) receive the opportunity to participate in the growth of a promising business. There is no doubt that without enough interest in IPOs (which is a derivative of secondary markets’ liquidity), venture capital and entrepreneurs will be robbed from one of their main exit strategies; therefore VC funds are likely to raise much less money and less projects will be funded. The end result is less start ups, less entrepreneurs, less jobs, slower technological progress and ultimatelly lower living standard for everyone.

Hopefully the Congress will not take short-sighted decisions that are going to worsen the liquidity of US secondary capital markets. Am I opposing new regulations? No – the systemic risk in the economy needs to be addressed and intelligent changes in regulation are needed. The simple, but optimal approach to decrease systemic risk is to limit the size of leverage and prevent “too big to fail” companies to participate directly or indirectly in OTC deals. If you are “too big to fail”, you need to be accountable and transparent. If you don’t like it, become too small to matter for the survivability of the financial system.

The most powerful forces against poverty are technological progress and entrepreneurship, which scope and success are directly dependent on the liquidity of secondary capital markets. Don’t kill the liquidity.