Hopes that we’ll get a vaccine against Covid-19 next year have increased the chances that there’ll be a good economic recovery, which in turn raises the prospect that inflation will rise. Equity investors, however, should not fear this prospect.
For one thing, any increase in inflation is likely to be moderate. Yes, the Bank of England has been printing money. But as we learned in 2009, this is not necessarily very inflationary because this increased supply has been matched by increased demand. And insofar as that demand for money does recede, it is more likely to lead to rising share prices than to rising consumer prices.
Instead, the inflation threat, such as it is, comes from more mundane sources. It’s simply that there’s likely to be a degree of mismatch between unemployed workers and the vacancies that are available, while a swathe of business failures could increase the pricing power of surviving companies. A pick-up in demand might therefore raise prices even while there appears to be lots of spare capacity in the economy. History tells us this does indeed happen: inflation rose soon after the recessions of 1991-92 and 2008-09. But it also tells us that such rises are shortlived, and inflation falls back as the mismatches fade away.
One big fact suggests that equities could actually benefit from a little more inflation. My chart shows that there’s a good correlation between the All-Share index and the gilt market’s expectations for inflation in the following five years. Falling inflation expectations in 2008, 2011-12, 2015 and earlier this year were accompanied by falling share prices, while rising inflation expectations in 2009, 2012-14 and 2016 all saw shares rise too.
This happens despite the fact that rising inflation expectations are usually accompanied by expectations of higher interest rates, which you’d expect to be bad for shares.
What’s going on here is simple. Inflation expectations are cyclical: they rise in better economic times as markets anticipate a stronger economy, causing higher inflation. But these same better times also raise expectations of corporate earnings and investors’ appetite for risk, pushing up share prices.
From this perspective, it’s no surprise which sectors have usually done best when inflation expectations rise. Post-2005 relationships tell us that cyclical ones such as construction, transport and IT usually outperform then, while defensives such as telecoms, food retailers and utilities benefit less.
Aim shares, as a group, also benefit when inflation expectations rise. This is because they tend to be speculative, sentiment-driven stocks and so benefit from any rise in investors’ appetite for risk. Yes, history tells us Aim shares as a whole are bad long-term investments. But they can be good short-term plays on improving sentiment.
There is (as you’d expect) a caveat here. All this is true only of moderate rises in inflation expectations. If we were to see a big rise, however, it’s likely that shares – and especially cyclical ones – would actually fall as investors anticipated the Bank of England raising rates to combat the higher inflation. Such a scenario is, however, unlikely for now. The lesson of the past 30 years is that inflation is surprisingly stable in the face of huge swings in economic activity, commodity prices or monetary growth. This points to inflation and inflation expectations rising a little, not a lot.
You might think that gold or commodity prices are also a way of playing a rise in inflation expectations.
Not really. The correlation between gold and the five-year breakeven inflation rate has been weak in recent years. Since 2005, it has been only 0.16 (measuring gold’s price in sterling terms) compared with a correlation of 0.61 between the All-Share index and breakeven inflation. That means the chances of gold rising when inflation expectations rise are only a little better than 50-50.
There’s a reason why this correlation is weak. Yes, gold should do well if people expect higher inflation. But this is offset by two other mechanisms. One is that the same cyclical upturn that raises inflation expectations also raises investors’ appetite for risk, which causes them to dump safe-haven assets such as gold. The other is that a rise in inflation expectations is likely to raise bond yields, and rising bond yields increase the opportunity cost of holding gold and so depress its price: why hold an asset that pays no yield when other assets pay a decent income?
Net, these mechanisms mean that gold is a poor way of playing a moderate rise in inflation expectations. A better way of doing so is via equities.