Allocations for inflation (part 6): equities
In the final part of our series on the asset allocation response to inflation, we look at equities. The traditional view is that equities exhibit real-asset-type qualities and are thus a relatively good place to be in a period of rising inflation. While we agree with that general statement, the relationship is a bit more complicated in the details.
Empirically, equities have delivered positive excess returns in environments of high and/or rising inflation, even if returns in those periods were lower than in others. The same applies to real assets such as infrastructure and especially to REITs.
However, our work also finds that inflation is rarely the dominant a driver of returns for these real assets. That means it is important not to rely too heavily on inflation to build an equity, REIT or infrastructure investment case.
Earnings giveth, but valuations taketh away
Fundamentally, there are two main effects of inflation on equities, which partly offset each other: earnings rise with inflation, but valuations decline. Higher prices naturally inflate revenues. This will be partially offset by higher costs, but assuming a significant proportion of the cost base remains fixed the net effect of inflation should be and has been higher earnings.
The offsetting effect to higher earnings is that inflation tends to cause the price-to-earnings (P/E) ratio of equities to fall. As the next chart shows, inflation of more than around 3% has a marked impact on the P/E ratio.
Higher inflation will drive up bond yields, and with that the discount rate for the inflated corporate earnings also increases. Historically, equity valuations have been highest when inflation was moderate. Deflation and high inflation have depressed valuations, though for different reasons.
Winners and losers within equities
While inflation’s effects on equities in general can seem relatively straightforward, it can be more difficult to differentiate between the winners and losers from these effects.
In general, commodity sectors and banks have exhibited the highest betas to rising inflation. Cyclicals have tended to do better than defensives, especially if inflation is linked to strong growth.
But sector correlations with inflation have been anything but stable over time – and how much do sector patterns from a low inflation environment really tell us about the future? A qualitative approach can help us answer these questions.
There are four company characteristics that should help them deal successfully with rising inflation:
- Relative pricing power. Companies that are able to raise prices by more than the average rate of inflation (the CPI) and also have pricing power over their suppliers to control input costs, ideally even when product demand is flat.
- Debt to inflate away. Some nominal debt is beneficial as it shrinks in real terms and debt servicing becomes easier. But too much debt can become an issue should debt availability become an issue.
- Ability to scale without much capex. Capex can become very expensive and difficult to earn an adequate return on, so companies that can scale, via prices or volumes, without capex (e.g. software firms) have a great advantage.
- Low labour cost exposure. Rising wages can quickly become a problem for some companies with low margins and labour-intensive business models that cannot be substituted.
- In the first blog in this series, Chris Teschmacher introduced the problem with inflation for multi-asset investors.
- In the second, John Roe analysed the key questions for managing inflation in a multi-asset portfolio.
- In the third, Chris Jeffery looked at the implications for fixed income.
- In the fourth, Willem Klijnstra considered the role of currencies.
- In the fifth, John Southall explained the differences between hedging inflation, keeping pace with inflation, and generating returns from inflation.