This is simply because history shows that inflation is usually bad for shares. In annual data since 1900, the correlation between the inflation rate and the dividend yield on UK equities has been 0.3, implying that, more often than not, higher inflation is associated with falling equity valuations. This correlation is flattered by the fact that deflation in the 1930s was also bad for shares. If we look only at years in which inflation was positive, the correlation between it and the dividend yield is a hefty 0.42.
This tells us that positive but low inflation is best for shares.
For example, rising inflation after World War I, in 1940-41, at the start of the Korean War in the early 1950s, in the 1970s, 1990 and 2008 all saw the dividend yield rise and share prices fall. Conversely, falling inflation in the 1980s helped share prices boom.
You can be forgiven for being surprised by this. Inflation doesn’t affect long-run growth, except when it reaches very high levels so in this sense it should hurt shares. And it reduces the real value of debt, which should help companies.
So why is it so bad for shares in reality?
One reason was pointed out 30 years ago by the Nobel laureate Franco Modigliani and has been corroborated by later research. It’s that investors are prone to a form of money illusion. When inflation and nominal interest rates rise, they discount future cashflows at the higher nominal interest rate but fail to see that the same inflation that causes a higher discount rate also raises the nominal growth of those cashflows. The upshot is that future cashflows are discounted too much, causing shares to fall further than they should.
There are, however, two more rational reasons for inflation to hurt shares.
One is that it is often associated with the end of economic booms - as in the mid-70s, 1990 or 2008. This could be because rising costs of raw materials and labour not only raise prices but also squeeze corporate profits. Or it’s because central banks raise interest rates to choke off inflation, which also depresses growth. Either way, the weaker economic activity which inflation either causes or signals leads to increased risk aversion and thus lower share prices.
Secondly, higher inflation is usually associated with increased uncertainty; it’s no accident that it is also associated with increased savings ratios as people put more aside for a rainy day. Of course, any uncertainty unleashed by QE-generated inflation won’t be as great as in the 1940s or 1970s when the very existence of capitalist democracy was in question. But it would create uncertainty about how policy would respond to the higher inflation. And uncertainty is bad for shares both directly - by raising the risk premium - and indirectly, because it depresses economic activity.
History and theory, then, are clear. If you’re worrying that inflation will rise, you should probably be bearish of equities.
So why hold them? Simple. Although they are poor protection against inflation - you need index-linked gilts for that - they are good protection against the possibility that you'll be wrong and that QE will end not in inflation but in a return to nice real growth.
But then, all diversification is protection against being wrong - which is why we all need it.
