Equities as an inflation hedge

The history of the late 1960s and 1970s suggests that rising inflation was very bad for equity investors. From the end of 1965, when inflation started to heat up, through mid-1982, as inflation returned to single-digit levels, the S&P 500 index fell 62% in real terms. That disastrous performance, however, was almost exactly the same as the devastating real decline in the S&P 500 from its peak in 2000 to its low in March 2009. In other words, the bursting of the tech bubble followed by the bursting of the housing bubble were, in a sense, just as bad for investors as the 1970s collapse of the dollar and the emergence of double-digit inflation. 

Financial theory, however, suggests that equities should be a good inflation hedge, because nominal earnings tend to rise, over time, in line with the rise in the general price level. Recent action in the stock and bond markets appears to confirm this.

The above chart compares the S&P 500 index to the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices (which happens to be the Fed's preferred measure of inflation expectations). There is a noticeable tendency for equity prices to rise as inflation expectations heat up, and to decline as inflation expectations cool off. This action is particularly evident over the past year, as equity prices have jumped some 30% and inflation expectations have moved up from 2.1% to almost 3.0%.

As I noted a few weeks ago, the Fed's decision to implement QE3 succeeded in stimulating inflation expectations, if not the real economy. And looking back, it is the case that the current equity market rally began shortly after this same measure of inflation expectations hit an all-time low of 0.5% at the end of 2008 and began to rise. One driver of the current rally, in other words, has been rising inflation expectations. The Fed gets some credit for boosting stock prices, just as they can now take credit for having artificially depressed mortgage rates. Whether this means the economy will be better off, however, remains to be seen, because a rising price level does not necessarily translate into rising prosperity. Come to think of it, this helps to explain why the stock market has done so well even though the economy is suffering through its slowest and weakest recovery ever: much of the "improvement" in equity prices is merely a by-product of reflation, rather than genuine recovery. There certainly has been a good deal of reflation already: recall that in late 2008 the TIPS market was priced to 5 years of deflation. From expecting 5 years of deflation to now expecting inflation to average 3% per year 5 years from now is a huge difference—a lot of reflation.

If inflation does indeed move higher, in line with expectations, then sooner or later Treasury yields are going to have to move higher and the Fed is going to have to put QE3 on ice. But as I've argued repeatedly, higher Treasury yields—and higher interest rates in general—won't be a problem for the economy or for the stock market, since they will be the natural result of a stronger economy and/or faster nominal growth.

As for inflation hedges in general: Gold, long considered the classic inflation hedge, has enjoyed a spectacular run over the past decade. So maybe it's already priced in a lot of inflation. Commodities in general have enjoyed fabulous returns. Gold and commodities are arguably very expensive inflation hedges today. Real estate is also a classic inflation hedge. Nevertheless, with prices only recently on the mend after suffering a roughly one-third decline in price, real estate is arguably cheap. And stocks are arguably cheap as well, to judge from the fact that PE ratios are below average, yet corporate profits are at or near all-time highs, both nominally and relative to GDP.

I'm  not a fan of inflation, but it's obvious that the market is doing much better today knowing that the specter of deflation has been all but banished. Faster nominal growth provides good support for equity prices and corporate bond prices (better cash flow prospects mean read reduced default risk), but I'd rather seen real growth be the major component of that faster nominal growth, rather than inflation. The Fed is working hard to get nominal GDP growth to move higher, but by themselves they are only likely to push the inflation component of nominal GDP higher. To get real growth moving higher we need better fiscal policy and more confidence in the future. That's what the elections next month are all about.