- Even investors who are fundamentally bearish on the economy seem to have bought into the idea that rising inflation will allow stocks to post positive returns over the coming years.
- History shows clearly that the positive direct impact of high inflation on nominal earnings tends to be more than offset by contracting valuation multiples.
- The transition from low to high inflation has been associated with some of the worst returns in the history of U.S. stocks as the 1968 to 1982 period shows.
- It would likely take over a decade of 10% inflation for the positive impact on profits to offset the negative impact of even a historically mild period of valuation mean reversion.
During every market bubble there has to be a reason why traditional valuation measures no longer matter, otherwise we would not get to such extreme levels. In this current bubble it is the belief that policymakers will effectively bail out investors by keeping real interest rates deeply negative and debasing the currency to the extent that nominal GDP rises sufficiently to drive positive equity returns. Even investors who are fundamentally bearish on the economy seem to have bought into this idea.
I have detailed in a number of articles over the past year (see here and here) how there is no reason to expect negative real interest rates to support stock prices, and in this piece I will show how the same holds true for high inflation. In fact, history shows clearly that the positive direct impact of high inflation on nominal earnings tends to be more than offset by contracting valuation multiples.
The link between inflation and equity prices is much more complex than most investors seem to realize. It is true that periods of reflation - the transition from low rates of inflation to average rates of inflation - tend to be highly beneficial for stocks as we are seeing today. It is also true that periods of persistently extreme inflation tend to lift stocks in nominal terms, particularly over the long term. However, the transition from low to high inflation has tended to be associated with some of the worst returns in the history of U.S. stocks. Investors banking on monetary debasement allowing stocks to grow into their extreme valuations should be careful what they wish for. It would likely take over a decade of 10% inflation for the positive impact on profits to offset the negative impact of even an historically mild period of valuation mean reversion.
The Evidence: Rising Inflation Undermines Equity Valuations
The most inflationary period in U.S. history occurred between the late-1960s and the early-1980s, which also happened to be one of the worst periods of SPX equity returns on record. From its peak in November 1968 to its trough in July 1982 the SPX went precisely nowhere despite an almost tripling of the official consumer price index. During this period the SPX also experienced a maximum peak-to-trough decline of 48% which took place between December 1972 and September 1974 as consumer prices rose 20%. Low inflation periods have also proved to be the best periods for SPX returns. From September 1953 to December 1961 inflation averaged just 1% per year while the SPX delivered 20% per year in total returns.
SPX Vs CPI
The inverse relationship between inflation and equity prices is entirely explained by the behavior of valuation multiples. The next chart shows the correlation between the 10-year CAGR of the consumer price index and U.S. market capitalization as a share of GDP. As inflation rises, valuations fall. Furthermore, the higher inflation goes, the closer the correlation between the two becomes.
SPX Valuations Versus Inflation Rate
The Theory: High Inflation Stems From Economic Weakness And Creates Uncertainty For Investors
As much as the historic evidence supports the notion that inflation is bad for stocks, it is not enough to rely on history alone without understanding why the relationship exists. The main reason likely stems from the fact that periods of high inflation tend to result from and also cause economic weakness. Contractions in output tend to drive up prices and encourage deficit spending and money printing, which further exacerbate economic weakness. We can see from the chart below the inverse correlation between real GDP growth and inflation. If we are to experience double-digit inflation over the coming years it will almost certainly be because the economy is in a horrible state.
Another factor is that high inflation periods also tend to be volatile inflation periods which makes forecasting returns much more difficult for investors. High and rising inflation also raises the prospect of an uncontrollable surge in interest rates and fiscal tightening in order to bring inflation down. This combination of the two makes it particularly difficult for investors to be confident in any kind of discounted cash flow analysis and they therefore tend to require much higher equity risk premiums.
Extreme Valuations Mean Huge Scope For Contraction
If valuations were anywhere close to normal levels we would be much less concerned about the potential for multiple contraction. However, U.S. market capitalization as a share of GDP is currently 3.4x its historical average and 7.3x the levels seen the last time inflation was at double-digit levels. This means that even if valuations were to mean revert to historical averages this would still more than offset the impact of higher inflation on nominal earnings and dividend payments. For instance, if we assume that real GDP growth averages 1% over the next decade (see 'Brace For Sub-1% Long-Term Growth') and inflation averages 10%, investors would still be worse off even in total return terms 10 years from now: ((1.11*(1/3.4)^(1/10)-1)+0.014)*100 = -0.4%
Breakeven Inflation Expectations Are Still Only 2.5%
For all the talk of surging inflation the bond market is pricing an average inflation rate of just 2.5% for the next decade according to 10-year breakeven inflation expectations. The rise from last year's low has been significant but current levels are still below the long-term average actual inflation rate. Of course, the bond market could be wrong, but it is an unbiased estimator that has done a good predictive job in the past. Interestingly, the 10-year breakeven rate is now actually above the 30-year rate for the first time ever, meaning that investors, bond investors at least, expect any rise in inflation to be transitory.
5, 10, 30-Year Breakeven Inflation Expectations
Can We Trust Official CPI Figures?
Discerning investors will no doubt question the reliability of current breakeven rates as they are based entirely on what investors expect official inflation prints to be, and there is a lot of incentive for official figures to be massaged down should inflation pressures begin to mount. However, it is tough to make the case that this is already happening as some have argued.
To see why, consider that from the 2008 peak to the 2020 peak total SPX sales grew by just 2.4% per year, while official CPI has averaged 1.5%. This means that in order to believe inflation has been underreported you would have to also believe that the actual growth in real output of SPX companies over this period has been less than 0.9% per year. This seems highly unlikely to say the least.
SPX Sales And CPI
Investors expecting currency debasement and the resulting price inflation to translate into higher equity prices over the coming years are likely to find themselves sorely disappointed if history is any guide. As noted above, it would likely take over a decade of 10% inflation for the positive impact on profits to offset the negative impact of even a historically mild period of valuation mean reversion.
Even with the unprecedented fiscal and monetary stimulus measures being undertaken at present we find it hard to believe that nominal GDP, let alone inflation, will average anywhere close to double-digit levels over the next decade. We certainly cannot rule it out, but positioning for such an occurrence in U.S. stocks is folly, particularly considering gold is still relatively cheap and has a much better track record of preserving wealth during high inflation periods.
This article was written by
Analyst’s Disclosure: I am/we are short SPX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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