New research shows that stocks have historically been a poor hedge against inflation over anything but very long horizons, and investors worried about preserving the real value of their income and assets should prepare for a wider range of economic outcomes.
The conventional wisdom is that because stocks represent the ownership of real assets, they should be a good hedge against inflation. Unfortunately, conventional wisdom about stocks is often wrong. Stock returns have been about 10 times as volatile as inflation (about 19% versus about 1.8%), making them an unreliable hedge over anything but long horizons. For example, over the period December 1968 through December 1982, the S&P 500 Index returned 6.3% per annum, while the CPI increased at a rate of 7.5%. The result was a cumulative loss in real value of 38%. It’s hard to make the case that stocks are a good inflation hedge when they lost almost 40% in real terms over a 14-year period.
Eugene Podkaminer, Wylie Tollette and Laurence Siegel, authors of the study, “Protecting Portfolios Against Inflation,” published in the April 2022 issue of The Journal of Investing, examined the historical performance of various assets and liabilities relative to inflation and concluded that equity indexes only worked over a very long-term horizon. They also found that stocks were a negative hedge over shorter time frames, tending to fall when inflation rates rose.
Their findings are broadly consistent with those of Henry Neville, Teun Draaisma, Ben Funnell, Campbell Harvey and Otto Van Hemert, authors of the study, “The Best Strategies for Inflationary Times,” published in the August 2021 issue of The Journal of Portfolio Management. They analyzed the performance of a variety of asset classes for the United States, the United Kingdom and Japan since 1926 to determine which have historically tended to do well (or poorly) in environments when year-over-year inflation was accelerating and when the level moved to 5% or more. They found that no individual equity sector offered significant protection against high and rising inflation. Even the energy sector was only slightly better than flat in real terms. Weak sectors included those with a high exposure to the individual consumer, such as durables (-15%) and retail (-9%). Technology was also weak, at -9%. Financials were weak (-9%) because default risk dominated the benefits of possibly rising rates and because there can be a lag between an inflationary regime and central bank tightening.
Latest research
Sangkyun Park, author of the study “Stocks as a Hedge against Inflation: Does Corporate Profitability Keep Up with Inflation?,” published in the August 2023 issue of The Journal of Investing, used monthly stock market data covering more than 151 years, from 1871 to 2022, to analyze the relationship between inflation and corporate profitability measured by dividend-equivalent earnings (DEEs) discounted at the risk-free rate. The authors explained: “DEEs are hypothetical earnings that would result if all earnings were paid out as dividends. The risk-free interest rate reflects the rate of inflation, intertemporal preferences of consumers and investors, and monetary policy. The discounted value of DEEs is intended to capture the intrinsic value of cashflows from stocks, which should be proportional to the fair value of stocks.” Here is a summary of his key findings:
- In the very long run, corporate profitability kept up with inflation. But over 10-year horizons, the relation between inflation and corporate profitability was irregular – the relation between corporate profitability and inflation varied across sample periods, time horizons and ranges of inflation.
- Corporate profitability was so volatile that inflation could, at best, explain a small fraction of changes in corporate profitability.
- An increase in the rate of inflation could be favorable or unfavorable for corporate profitability. For example, it was favorable when it reflected recovering demand and unfavorable when it reflected upward pressure on production costs. The latter was more likely when inflation was already high. Thus, corporate profitability tended to be positively related to demand-pull inflation and negatively related to cost-push inflation.
- Corporate profitability was highest when inflation was modest (0%-4%), and it was very low when inflation was very low (deflation) or very high (over 10%). Since very high inflation or deflation tended to occur during a prolonged period of economic instability, it may have been economic instability that lowered corporate profitability rather than inflation itself.
His findings led Park to conclude: “It is hard to find a robust relation between inflation and corporate profitability because it is so unstable. … What really matters for corporate profitability seems to be long-term economic stability, as opposed to a temporary setback. High inflation, itself, may not lower corporate profitability, although it can signal lower corporate profitability. Negative stock market reactions to high inflation itself may create buying opportunities.”
Investor takeaways
While many investors believe equities provide protection from inflation (a firm’s debt obligations are inflated away, and product prices may be adjusted to inflation), over 10-year and even longer periods equities have not provided a strong inflation hedge because they have tended to suffer from a less stable economic climate (the rate at which future earnings are discounted rises, lowering valuations), and costs tended to rise with inflation more than output prices. Despite the poor performance of equities in high and rising inflationary regimes, equities benefited from rising inflation when the starting level was below the median (when there was risk of deflation) but were hurt by rising inflation if the starting level was above the median (when there was increased risk of escalating inflation). But today the core CPI is still above the historical median rate of inflation (about 3% since 1926).
Even if you are optimistic that the Federal Reserve can manage to lower inflation to its target of 2% without having to drive up real interest rates to levels that would dampen demand sufficiently to cause a recession, hurting corporate profitability, the dispersion of possible outcomes you should consider should be wider than it was over the past two decades when inflation was highly stable. It may be a good time to review your asset allocation in the face of heightened inflation risk.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
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New research shows that stocks have historically been a poor hedge against inflation over anything but very long horizons, and investors worried about preserving the real value of their income and assets should prepare for a wider range of economic outcomes.
