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Are all equities a good inflation hedge? By Marc Lerner

Are all equities a good inflation hedge?

Zero Hedge has reposted a UBS report entitled ‘Are equities a good inflation hedge?’ The report
investigates this question through a study of historical data of equity performance in various inflationary and deflationary price environments, and concludes:

Indeed, they [equities] provide an appropriate hedge to rising inflation only in a limited number of cases.

1. The trade has to be entered at a low level of inflation. If the trade is started above 4%, the
valuation loss due to declining P/E will dominate and make equities underperform.

2. If inflation increases only moderately. High-single-digit inflation would make the equity valuation
loss dominate other effects.

3. If the investor assumes that inflation will not decline. In that case, the trade would also generate
sub-inflation returns. So an equity hedge comes with increased portfolio risk in cases of deflation.

The main problem with the report’s approach in reaching these conclusions is that it does not attempt at all to focus on the effects price inflation – a sustained, general increase in prices – may have on individual businesses and their earnings. Whilst it does pose some interesting arguments on a macroeconomic level – for example, that higher inflation may lead to higher volatility and hence higher discount rates being applied to cash flows – and provide empirical data to support them, it only in passing mentions that “some price distortions can obviously affect corporate margins”, instead simply presenting the aggregate returns of stocks in general under inflationary and deflationary environments, as if all equities were homogenous. The report can’t see the trees for the forest. But if you are interested in the performance of specific companies in an inflationary environment, rather than a broad equity portfolio such as an index fund, this effect on margins is precisely the crucial issue, and well worth investigating further.

In the near term, the most likely source of price inflation is money printing from central banks, rather
than some other source, such as a supply shock. The effects of such monetary expansion are never even – prices will rise first wherever the new money enters the economy (relative to what they otherwise would have been – a relative price ‘increase’ can still be, in absolute terms, a decrease). If it is used to purchase government bonds, wherever the government spends the money will experience rising prices, if mortgage backed securities are purchased then rising house prices will result. By unevenly distributing the price increases in this manner, money printing can allow the early recipients of the money to benefit at the expense of the latter ones – by the time the money filters through to them, their costs have already increased correspondingly. Therefore, if it can be determined that a company’s output will be purchased directly by the new money flows before they spread through the economy to affect its costs, aggressive margin expansion and high returns to shareholders are likely to be the outcome. Finding such companies, however, is essentially a political question and hence a difficult one to answer accurately, unless you happen to be friends with Ben Bernanke.

More broadly, as the money does move through the economy and affect consumer prices as well as costs, the crucial question becomes whether or not a business can raise its prices to offset, and perhaps even outpace, the increase in its costs. The extent to which different businesses’ costs are affected depends, again, on the way the new money moves through the economy, and will differ in each case. For consumer businesses in particular, however, the question of whether prices can be raised to an appropriate degree takes on an especially interesting psychological dimension – will consumers be willing to pay higher prices? One consideration could be the extent to which the specific business’s customers themselves are in a position to benefit from the increased money flows earlier rather than later – if the business is one that caters to a particular, easily identifiable demographic. Another argument could be made, however, that the absolute value of the price increase is of importance – a 10% increase in the price of a Coke, for example, may not seem like much to most people in terms of the extra amount they have to pay, and hence not affect Coca-Cola’s ability to raise prices in tandem with inflation, whereas a 10% increase in the price of a house or a car could be seen as a serious cost-of-living increase, and hence such purchases may be delayed or cancelled until prices stabilize or fall.

Marc Lerner