quities have been an essential source of long-term return in many diversified portfolios. But do stocks also deserve their reputation as investments that can potentially hedge inflation? Not uniformly. To maximize equity return potential, we believe active management is imperative – in particular, stock selection that is informed by a view on inflation and how it affects specific companies.
As with most asset classes, the potential of equities to hedge inflation depends more on changes in the rate of inflation than on its absolute level. If inflation is high but stable, equity prices would likely embody current inflation expectations. But a jump in inflation, often accompanied by escalating interest rates, is more likely to be detrimental to equity returns. It can pressure price-to-earnings (P/E) multiples in several ways, including through:
- Higher capital costs
- Higher discount rates applied to future earnings or dividends (which lower net present values)
- Higher input costs
Our analysis of historical data shows that low levels of inflation have been supportive of P/E multiples, with the highest levels occurring when inflation ranged from 2% to 3%. But P/E multiples declined steadily as inflation accelerated above this level. They also fell when inflation was negative or close to zero, most likely because extremely low inflation resulted from economic weakness (see Figure 1).
Despite these patterns, the relationship between inflation and individual equities remains complex and idiosyncratic. Fortunately, we were able to tease out these dynamics by analyzing more than a half century of data (see “Hunting for Beta Data”).
Broad equity returns have not intrinsically provided a good hedge against inflation. Thus, selecting stocks for their inflation-hedging potential requires that an equity portfolio manager not only be unusually vigilant about the risk of approaching inflation, but exceptionally well-informed about how a company will likely perform in varying inflationary environments.
A “safe haven” in natural resource stocks?
Some investors have sought to hedge inflation risks by investing in natural resource stocks. Regrettably, however, these stocks have not always been a satisfactory refuge. Our analysis, as well as academic research (see Gary B. Gorton and K. Geert Rouwenhorst, “Facts and Fantasies about Commodity Futures,” February 28, 2005. Yale ICF Working Paper No. 04-20.) indicates that equity risk factors drive returns of natural resource stocks more than inflation risk factors. Reasons for this loose connection between natural resource equities and inflation include:
- Commodity producers, for good reason (such as promotion of stable earnings), may hedge their production. In return, they do not get the full benefit of rising prices.
- Commodity producers may be hurt by factors that actually increase commodity prices. For instance, a strike at a copper mine might lead to higher prices, but it can also limit production.
- Natural resource companies may include debt in their capital structure, leading to higher costs of capital if interest rates rise.
The bottom line: Natural resource equities have the potential to hedge inflation only in diluted form. Without doubt, broad commodities futures indexes offer a more direct and concentrated vehicle for capturing inflation risk (more inflation beta per dollar invested). Unfortunately, however, not all equity investors have the knowledge, experience or flexibility to make such an allocation.
Managing equities for inflation
What attributes can cause a stock to provide a potential hedge against inflation? Our analysis identified three key attributes that may help companies and their investors withstand, or even benefit from, inflation.
Pricing power is critical to a company’s ability to pass along high input costs. It can be exerted by companies with a brand name or dominant (oligopolistic/monopolistic) market share. A brand-name consumer staples company with pricing power, for example, could pass rising wage or commodity costs onto customers without losing market share, unlike generic providers.
A key benefit is wider profit margins. For example, a hypothetical brand-name company with 40% margins that experiences 10% input cost inflation can either flex its pricing power by passing on higher costs via a 6% price increase, or maintain its prices and experience a 15% margin compression. In contrast, a generic competitor with only 20% margins and no pricing power in the same inflationary environment will either have to raise prices by 8% to pass along higher costs or maintain its prices but see margins compress by 40%!
Supply side advantages
Supply side advantages can give firms a way to defend against rising costs. Structural advantages include characteristics such as location or access to raw materials that competitors cannot duplicate. For example, in an environment characterized by commodity inflation, an oil and gas company with access to cost-advantaged hydrocarbons from non-traditional reserves could allow some participants in the supply chain to generate higher profits. On the other hand, an oil and gas producer may be subject to a royalty agreement whereby it pays a higher percent of revenue to the host country as prices increase, which could prevent it from taking full advantage of inflation.
Given today’s low-yield environment, income is a key objective of many equity investors. Inflation has the potential to erode the value of dividend income, and for this reason equity investors should focus on companies that have a potential willingness and ability to boost their dividends over time at a rate that exceeds inflation. Sustainability is critical, so the expansion of dividends ought to be funded by mounting free cash flow as opposed to rising debt, falling cash on the balance sheet, or an increasing payout ratio.
Even though not all equities may hedge inflation equally, stocks will likely continue to be a core component of most diversified portfolios over a full range of economic scenarios. For equities to realize their long-term potential as a key source of portfolio returns, however, it’s critical that managers seek to anticipate inflation and actively identify the securities that are less likely to be hurt by – or more likely to benefit from – inflation.
Hunting for Beta Data
What’s the inflation beta of equities, the extent to which stock prices keep pace with inflation? More specifically, how may a one-percentage-point change in the rate of inflation (rather than its absolute level) affect the magnitude of equity returns?
To find the answers, we analyzed equity price data from 1960 to the end of 2012, a period covering a variety of economic environments. During this period equities had an inflation beta of -1.93 (meaning that a one-percentage-point increase in the rate of inflation as measured by the CPI resulted in a 1.93-percentage-point decline in equity returns), and a correlation to changes in inflation of -0.21. For an even longer perspective we looked at the level of price-to-earnings (P/E) multiples compared to inflation regimes during the last 140 years. When we used a rolling 10-year-average P/E (often called the Shiller P/E), multiples were at their highest when inflation was 2% to 3% (see Figure 1). As inflation rose above that level, P/E multiples declined.
For natural resource stocks, the inflation beta from 1960 to 2012 was only 1.54 (see note). During this period, the correlation of inflation to natural resource stock returns was only 0.16. We then analyzed the risk factors that were driving this slightly positive inflation beta. By regressing natural resource stock returns against a broad equity index as well as an index of commodity returns, we found that the factor sensitivity to equity returns (0.7) was larger than the sensitivity to commodity returns (0.5).
Applying these factor sensitivities to the inflation beta of commodities and broad equities, we derived a weighted-average inflation beta of 1.56 – remarkably close to the natural resource inflation beta that we had calculated directly. Furthermore, commodity returns were higher during periods of high inflation while natural resource equity returns were higher during normal inflation, when an inflation hedge was not as essential.
Note – See Disclosures for additional index description and methodology.
– Bob Greer and Raji Manasseh