Tuesday, December 18, 2012

Equities as an inflation hedge

My first post on this subject was in early October. Time for an update, since the meme continues.


The above chart compares the S&P 500 to the bond market's forward-looking inflation expectations. Since the third quarter of last year, both equity prices and inflation expectations have moved higher in a meaningful way. It would seem that the Fed's quantitative easing efforts deserve some credit (or should I say blame?) for this. Higher equity prices owe more to rising inflation expectations than to stronger growth expectations. Inflation are not necessarily bad for equities, as I explained in my earlier post, because corporate earnings should tend to rise as the price level rises.

Another "benefit" to higher inflation is that it boosts tax revenues. Incomes tend to rise with increases in the price level, and that moves people into higher tax brackets (thanks to our progressive tax code), with the result that federal revenues rise without the need to increase tax rates, even if the economy remains weak. That's been the story for the past few years: a very weak recovery but with ongoing inflation of 2% or so has caused federal revenues to increase at a 6.3% annualized pace over the past three years, even as nominal GDP has grown at only a 4.2% annualized pace.

Another "benefit" to higher inflation is that it reduces the burden of federal debt. That is especially the case today, since yields on Treasuries are significantly lower than current inflation. Negative real interest rates allow the federal government to pay back its debt with cheaper dollars. This, together with the revenue-boosting effect of higher inflation can result in a substantial decline in the federal deficit burden. Already we have seen the federal deficit fall from a high of 10.5% of GDP to today's 7.0%.

While it's good to see debt burdens decline—especially since they are so large—inflation is not the best way to do it. Today's 2-3% inflation, in the context of negative real interest rates on almost all maturities of Treasury securities, is transferring significant wealth from the private sector to the public sector. Over time, this will result in economic growth that is disappointingly slow. And of course that is what we have seen so far in this recovery, the weakest one in modern times.

I don't see things changing meaningfully as a result of the fiscal cliff negotiations. Both fiscal and monetary policy are contriving to continue to transfer wealth to the federal government, and this will keep the economy weak for the foreseeable future. This doesn't mean a recession, just more of the same very slow growth we have seen in recent years.

So I think it still pays to be an equity investor, even though the economic outlook is not very bright. Equities are relatively cheap (i.e., PE ratios are below average at a time when corporate profits are very strong) and they are thus one of the cheaper inflation hedges available to investors at this time.

11 comments:

NormanB said...

During the Great German inflation of the 1920's German stocks kept up and beat inflation (as good as the data was 80-90 years ago) so stocks as an inflation hedge does have some historical validity.

Dr William J McKibbin said...

I concur with Scott -- however, I would add that QE4 is not going to be an inflation creator -- rather, QE4 will find its way into private dealings around the world by banksters along Main Street -- QE4 is very much a monster that cannot be accounted for -- in fact, something is very awry with its creation -- I understood QE3, but not QE4 -- I regret that we the people may have been sold out on this deal...

Dr William J McKibbin said...

PS: Note that QE4 treasury purchases are to be unsterilized -- something somewhere will have to give as a result -- I am very confused by QE4 -- all I can conclude is that QE4 has nothing to do with macroeconomics, and everything to do with corruption between the Fed and Wall Street...

Mark Gerber said...

I understand the value of stocks during inflationary cycles, but aren't some alternatives such as gold superior? I'm thinkink of the 70's when stocks held their value but gold soared making gol the better choice, ay least until the Volcker Fed raised the fed funds rate to double digits to break the back of inflation.

Scott Grannis said...

Re gold as an inflation hedge. It's my belief that gold's huge runup over the past decade has been driven by the anticipation of a big increase in inflation. Gold is not cheap at all, given that its average real price over the last century is a little over $500/oz.

Equities are still cheap, as is real estate. Either one is a more sensible inflation hedge in my view.

Benjamin said...

Again, I find concerns about inflation to be mysterious.

The Cleveland Fed Index of Inflationary Expectations is at record lows.

Japan went to zero bound, and minor deflation ,in the early 1990s and never got out. It is still there. The Japan economy, in nominal terms is smaller today than in 1992. Japan did try QE from 2001 to 2006, with some success, as advised and then praised by John Taylor, GOP solon and star Stanford economist.

But they gave it up, and went back to deflation.

In Japan's deflation, equities and property have tumbled 80 percent.

Ironically, the very program that Scott Grannis says he fears---sustained QE by the Fed---might be what saves the USA equities and properties markets.

BTW, I am still puzzled by Grannis' depiction of sustained QE as "Fed borrowing" when the rest of the econ profession refers to QE as "Fed money creation" or the "printing of money"

I contend QE is money creation, and the wiping out of federal debt, and that we should be dang glad for both, and the Fed ought to do more.

This was also the advice give by Milton Friedman to Japan.

http://www.hoover.org/publications/hoover-digest/article/6549

In this fascinating discourse, you read Milton advising japan to print money aggressively until they saw strong economic growth and then inflation.

Have the calls for "tight money," once a sensible response to the 1970s inflation, have ossified into dogma?

Or we doomed to Japaization?

Or will a slightly higher inflation target 2percent in the case of the Fe---instead of 0 percent for the Bank of Japan---result in a long-term slow growth, with very low inflation?

Time wil tell.

Joseph Constable said...

From my previous comment on the previous post:

On the Fed balance sheet- Fed buys the bonds: Debit asset "Bonds", Credit liability "Reserves".

A liability is the same as a borrowing. Created money, not money but "base" money, is put into the commercial banks "reserve account" This is a demand deposit to the benefit of the commercial bank. It is an asset to the commercial bank and a liability to the Fed. A "borrowing" for which the Fed pays interest at a rate of .25%. It is a borrowing in the same way that the commerical bank borrows from its depositors. The commercial bank is a depositor at the Fed.

When the commercial bank withdraws their "reserves" and spends, lends, or invests it into the economy it becomes money.

brodero said...

A simple measurement...compare S&P 500 earnings yield to Baa corporate yield

William said...

Index..................1 Year Return
Dow Jones Industrial Ave...+13.47%
S&P 500 Index..............+20.03%
NASDAQ Composite Index.....+19.54%
New York Stock Exchange ...+19.00%
S&P/TSX Composite Index....+6.89%
Mexican Stock Exchange I...+27.77%
Bovespa Brasil Sao Paulo....+7.78%

steve said...

if and until labor tightens there will be no inflation. don't hold your breath.

JJ Butler said...

Conversely, high inflation will mean lower multiples...