Capital Ideas^TM

After a long hiatus, the resurgence of inflation has become a key concern for investors over the past year. Central banks are moving towards a tighter monetary stance as they seek to tame long-term inflation expectations. With falling real incomes dampening consumer spending, rising input costs eroding profitability and higher discount rates hurting the present value of future cashflows, we consider the effects that inflation have had on equity valuations in the past and review ways to build resilience into equity portfolios. Looking ahead, dividend-income investment could play a more important role in the total return of a portfolio.

Inflation is not necessarily bad news for equity valuations. Some inflation can be beneficial for companies’ bottom lines as it allows them to raise prices and protect profitability in ways they may not have been able to do in recent years. It also helps banks and commodity-linked companies that have struggled in a low inflation, low interest rate environment.

Even during times of higher inflation, stocks have generally provided positive real returns (see chart below). Global equities have historically provided an effective inflation hedge when US inflation is between 2-6%, powered by real earnings growth and real dividend growth. It’s mostly at the extremes (when inflation is above 6% or negative) that global equities have tended to struggle. However, sustained periods of elevated inflation are rare. The ultra-high inflation of the 1970s was a unique period, while deflationary pressures, such as during the Great Depression, have often been much more difficult to tame.

The relationship between inflation and stock prices is not linear

The impact of inflation on earnings can be quite positive in nominal terms, especially over the longer term. However, it can create short-term headwinds for corporate cash flows, particularly for companies that report earnings on historic cost accounting (using the original price of assets), rather than on a current cost basis. With earnings being overstated, the need for working capital increases as companies must meet higher corporate taxes, sparking the risk of a short-term valuation de-rating. The net impact of these factors varies from cycle-to-cycle and industry-to-industry.

The impact of inflation on valuations varies depending on the level of interest rates and the economic environment. When rates are high, future earnings get discounted back to a lower price, suppressing valuations. However, as interest rates decline, future earnings get discounted back to a higher price and hence valuations increase. Additionally, if the economy is in distress, valuations decline quite sharply reflecting the poor outlook for earnings, whereas, if the economy is relatively robust, valuations have followed a more linear path, i.e., lower rates mean higher valuations.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.