To what extent is the past a guide to the future? This question is key to whether equity investors should be worried by the possibility of higher inflation.
Recent history suggests we have little to fear. For example, CPI inflation was above its 2 per cent target for much of 2005-07 and 2012-13 and yet shares did well then – much better than they did in 2015-16 when inflation was near zero. This tells us that above-target inflation need not be bad for equities.
Taking the post-1995 period as a whole, the correlation between annual CPI inflation and annual changes in the All-Share index has been a mere 0.14, meaning that above-average inflation is slightly better than not for the market. The correlation has been higher than this for oil and engineering stocks but for several important sectors such as banks, retailers, tech stocks and utilities it has been close to zero. And no sector is significantly negatively correlated with inflation. This suggests that equity investors can pretty much ignore inflation as its impact upon the aggregate market and most sectors has been small.
Which shouldn’t be surprising. To some extent, inflation is predictable which means that it should be discounted by investors in advance. The data suggest this is largely the case.
But what about inflation surprises? One gauge of these is how inflation expectations change. We can measure such expectations by looking at the breakeven inflation rate, the difference between conventional gilt yields and their index-linked counterparts. When we do this, we see that higher inflation expectations have in recent years been good for equities. Rises in them in 2010-11, 2016-17 and in the last 12 months were all accompanied by rising share prices.
The evidence, then, seems clear. Equity investors should not be worried by rising inflation. If anything, it is good for the market.
Such evidence, however, could be very misleading. In recent years inflation expectations have been largely a measure of the state of the economy: they have fallen in downturns and risen in recoveries. And equities, of course, have the same pattern. This is why cyclical stocks such as construction and industrials have been better correlated with inflation expectations than defensives such as utilities and tobacco.
But this need not continue. It’s possible that inflation will rise so much or stay high for so long that it will lead to significantly higher interest rates. In such an event, investors might reasonably fear that tighter monetary policy will hurt economic activity and so sell equities and especially cyclicals. If this happens, the link between higher inflation expectations and higher share prices will break down.
There’s a precedent for this, though we have to go back to 1994 to find it. Back then inflation expectations rose significantly and equities fell as investors feared higher interest rates.
And that episode was typical of the 1980s and 1990s. In 1989-90 equities also fell as inflation expectations rose. By the same token, falling inflation expectations in much of the 1980s and 1990s were accompanied by rising share prices as investors believed that interest rates would fall thereby prolonging the economic upswing.
From today’s levels, therefore, it is quite conceivable that higher inflation expectations would hurt shares. To believe that shares are safe from inflation is to commit the recency error – the tendency to attach too much weight to recent evidence and discard relevant evidence from earlier periods.
In fact, it’s possible that rising rates now would do even more damage than history suggests. If years of near-zero interest rates have pushed people into equities simply out of despair at returns on cash, then a rise in those returns could have a disproportionately harmful effect upon the market.
Now, my personal view is that higher inflation will be only temporary – the result of base effects (such as last year’s VAT cut on hospitality dropping out of the numbers) and short-lived localised shortages which market forces should eventually correct. But we must never base our investment strategy upon a forecast alone. We must consider the range of possible outcomes, and high inflation is within this range: to think otherwise is to be overconfident about our forecasting abilities.
Risk is sometimes defined as probability multiplied by impact. Those who are worried about significant inflation are, I suspect, mistaken about its probability. They might not, though, be so wrong about its impact.
