Do equities protect us from inflation? The answer, unfortunately for anybody wanting a simple story, is: it all depends.
In one sense, equities have protected us from inflation in the past simply because they’ve delivered above-inflation returns over the long run – at least if you had reinvested your dividends.
But life is not lived in the long run, but rather from moment to moment. And over shorter periods, things are more complicated.
In recent years shares have indeed protected us from inflation in the important sense that they have risen when inflation expectations (as measured by the gap between conventional and index-linked yields) have risen, and fallen when those expectations have fallen. In 2008-09 and in the spring of last year, for example, shares fell when inflation expectations fell and rose as those expectations rose.
This, however, is more a story about recession than inflation. In 2008-09 and in 2020 recessions reduced both inflation expectations and share prices, both of which recovered as the fear of recession receded.
In other periods, inflation has been terrible for equities. This was most obviously the case in the 1970s; UK shares fell more than two-thirds in real terms between 1971 and 1974 as fears of inflation emerged. But we don’t need to go back that far to see that inflation hurts shares. My chart shows the point. It plots the correlation between the five-year break-even inflation rate and the All-Share index: each point on the chart represents the correlation in the previous five years.
Although this correlation has been positive in recent years, this hasn’t always been the case. In 1989-90, for example, rising inflation expectations saw shares fall, because investors feared that rising interest rates would cause a recession. And as inflation expectations fell in the 1990s, shares rose because investors anticipated falling interest rates and prolonged economic expansion. And then in the late 1990s lower inflation expectations saw another rise in equities as investors hoped that cheap imports from China and fast productivity growth would both keep inflation down and raise economic growth. As such hopes faded in the early 2000s inflation expectations rose and shares fell.
If all this seems complicated, it shouldn’t be. It tells us that there are different types of inflation – some good for shares and some bad.
Good inflation comes early in an economic upturn, when the risk of deflation recedes and as investors look forward to economic growth resuming.
Bad inflation comes in two forms. One is what we might call 'late cycle' inflation, when capacity constraints raise inflation and investors fear that rising interest rates will depress growth. This is what we saw in 1989-90.
The other bad inflation is supply-side inflation. This occurred most dramatically in the 1970s when rising oil prices raised inflation and depressed economic activity. It can also happen – as we saw in the early 2000s – when pessimism about productivity growth raises inflation expectations while reducing hopes for economic growth.
All of which poses the question: if inflation expectations do rise further, will they be of the good or bad kind?
Since last spring we’ve seen the good kind – the sort that accompanies a receding fear of deflation and increased hopes of economic recovery. To the extent that the Bank of England keeps interest rates down and so fosters the recovery, we could see more of this.
The risk of bad inflation is that we could see supply constraints emerge quickly. Restaurants seeing full houses could raise prices while other companies enjoying a post-lockdown surge in demand could raise prices rather than expand production. Such inflation is more likely to the extent that shops, pubs and restaurants that have been closed by Covid never reopen.
We don’t yet know how the pandemic has damaged the supply-side of the economy. To the extent that it has, bad inflation is a danger.
We cannot be at all confident that equities will protect us from this over the next few months. But we know for sure that conventional bonds will not do so. And it’s likely that although index-linked bonds will protect us from bad inflation, they would do badly if we get good inflation, because stronger economic growth would raise real yields. And given that gold tends to fall when bond yields (real or nominal) rise, it won’t protect us either.
And this is why inflation is such a problem. It’s not that sustained high inflation is especially likely: it’s probably not. Instead, the problem is that inflation is a danger for even the best diversified portfolios. It is a low-probability but high-impact risk for investors.
