Inflated fears

Any economist who quotes Dashiell Hammett, the crime writer who gave us The Maltese Falcon and The Thin Man, is worth taking seriously. Step forward Jeremy Rudd, an economist with the US central bank, who featured in last week’s Bearbull. “Nobody thinks clearly, no matter what they pretend,” he wrote, quoting Hammett. “That’s why people hang on so tight to their beliefs because, compared to the haphazard way they are arrived at, even the goofiest opinion seems wonderfully clear, sane and self-evident.”

As a contribution to a paper on, say, cognitive bias – a subject extremely relevant to investing – the Hammett quote would be spot on. In fact, the quote comes from a paper late last year about the effect on inflation of expectations for inflation. And nowhere, Rudd reckons, are the views of economists goofier than on the relationship between price changes and expectations for inflation.

For starters, Rudd questions the theoretical basis for even thinking that expectations should influence future inflation. That said, he does acknowledge Milton Friedman came close in suggesting that workers go into wage negotiations with the likely future inflation rate built into the basis for their claim (assuming, of course, that the future rate would be higher than the current rate). Meanwhile, employers do the opposite – focusing attention on the current rate.

As to the empirical case that inflationary expectations can be measured as the trade-off between wage settlements, rates of employment and inflation, this is a non-starter – “the expected inflation terms in these models have been reified (ie, converted) into a supposed feature of reality that ‘everyone knows’ is there,” he says, “and this apotheosis has occurred with minimal direct evidence.”

This is good knock-about stuff coming from an economist. Much of the argument revolves around the fuzzy issue of ‘money illusion’ and whether or not it exists. This is the notion that people think in terms of current prices and not possible prices in, say, 12 months’ time. In the jargon, they think in ‘nominal’ prices, rather than ‘real’ prices. Clearly, in a simplified world, if pay negotiators only ever thought in nominal prices – ie, they suffer total money illusion – then the idea of inflationary expectations would be dead in the water. Yet there is plenty of experimental evidence to show that sometimes people suffer the illusion, sometimes they don’t.

Besides, on the other side of the wage-setting contest, employers suffer their own strain of money illusion; or, as Rudd observes, “what little we know about firms’ price-setting behaviour suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers”.

So, if inflationary expectations are really fixed by one set of the partially-sighted in competition with another set, where might this leave the poor old investor? The chart attempts to answer this by comparing the performance of the FTSE All-Share index as a proxy for UK-quoted companies since 1960 with the All-Share’s returns adjusted for inflation’s impact. If you can barely spot the difference in performance between the two, that’s the point – inflation made little difference to UK equity returns over that 60-year period. That – incidentally – is why the All-Share’s performance is shown as a line on the chart and its inflation-adjusted self is shown in columns; put both data sets in lines and they would blend into each other.

First, though, let’s clarify what is meant by ‘inflation-adjusted’; it’s sort of obvious, but is also misunderstood. Imagine an equity-market index starts the year at 1,000 and ends the year 10 per cent higher. Meanwhile, over the same period the inflation rate is 9 per cent. In nominal terms the index’s value is obviously higher by the year end – 10 per cent higher at 1,100. But even in inflation-adjusted terms it is higher, though only just – 1,001. Only if inflation is equal to or higher than the nominal rate of change will the index’s inflation-adjusted value fall.

Happily for equities that doesn’t happen often enough; or at least not in the period covered in the chart. For those years, the annual inflation rate was higher than the change in the index just 25 times and there was little difference in the cumulative inflation-adjusted return produced by the All-Share index from its nominally-valued self. Invest £100 in the All-Share at the end of 1960 and, by the end of 2021, its capital value (ie, dividends excluded) would have been £4,210. In inflation-adjusted terms the sum would have been £4,130, just 2 per cent less. Nothing to worry about then.

Yes and no. Do the same calculation for the previous 60 years (1900 to 1960) and the result is remarkably similar yet depressingly different. In the 60 years the inflation rate was higher than the nominal change in the index more often than not – 32 times higher against 28 times lower than the index. That might be a concern but, in fact, the inflation-adjusted outcome for the period was still very much like the nominal outcome.

And this is the depressing bit – both outcomes were lousy. Invest £100 in UK shares at the start of 1900 and 60 years later the sum would be £232. Meanwhile, the inflation-adjusted amount would be £231. To put it another way – and make the comparison even more stark – the real value of UK equities rose 41 times from 1960 to 2021 compared with just 2.3 times for 1900 to 1960. True, in a sense that might be no surprise. After all, in those 60 years there was just one decade, the 1950s, when annual compound growth topped 10 per cent and two decades, the 1900s and the 1930s, when it was negative.

However, for the purposes of the present exercise, the message is that inflation does not significantly erode long-term returns from equity investing. True, occasionally – and in the short term – it doesn’t look that way. For example, in 1974 inflation was almost 16 per cent, which may well have contributed to the All-Share index’s 55 per cent fall. Then again, 23 per cent inflation in the following year did not seem to have much effect on the index’s 140 per cent bounce (120 per cent in real terms).

One obvious reason for inflation’s bit part is that it may be as likely to lift nominal returns as to depress them. Another is that, in shaping company profits, there are so many other factors in the mix anyway. That much is implied by the volatility of corporate profits. To see this, consider the data in the table, which is based on returns for the All-Share index for the 22 years of this century. The index’s earnings (ie, net profits) are extracted by dividing year-end index values by the index’s trailing PE ratio. That might make the earnings data a bit contrived but the point is to focus on the almighty way that earnings bounce around compared with the staid way in which inflation changes. For example, the biggest jump in year-on-year earnings is almost 64 per cent, in 2010 as the global economy began to recover from the US sub-prime mortgage crisis of 2008-09. In contrast, the highest inflation has managed – so far – is 4.5 per cent in 2011.

Granted, there is always the possibility that this time it will be different. It rarely is and there are no obvious reasons why it should be so now. Inflation squeezes companies’ profits in the short term because, to varying degrees, it raises their costs, depresses demand while leaving their sales prices trailing behind. Depressed demand and sticky costs can push companies into a self-re-enforcing cycle of decline. But then the problem becomes one of deflation and depression rather than inflation. There was plenty of talk of that in the aftermath of the sub-prime crisis but not yet this time around, even if ‘stagflation’ is back in the commentators’ lexicon.

Meanwhile – and, again, to varying degrees – company bosses have the power and flexibility to respond by raising their own company’s prices, cutting its costs and becoming more productive. Sure, there is an element of the zero-sum game about this. If every company does it, they lock themselves into that cycle of decline. In practice, the weakest – the ones with the least pricing power – suffer most. Meanwhile, the strongest will capture the economies of scale that will enable new growth.

All of that is easier said than done, to put it mildly. Yet, within the context of investing, it is obviously better to hold equities – the beneficiaries of this power and flexibility – than, say, fixed-interest securities in periods of high or rising inflation. As to shares in what sort of companies, this week’s message, which rather runs counter to the one with which last week’s Bearbull concluded, would be along the lines, “it doesn’t much matter. If your aim is simply to see off inflation’s effects then an average, well-diversified portfolio – or a market tracker, come to that – is likely to do the job”.

Besides, trying to understand today’s inflation and its possible effects may be as much a waste of time as such study has been in the past. As Jeremy Rudd, the economist with whom we started, says, “Our understanding of how the economy works—as well as our ability to predict the effects of shocks and policy actions—is in my view no better today than it was in the 1960s”.

Want to hear more from Bearbull? Listen in to this rare podcast, recorded this week, for more on his investment outlook and philosophy.