Repeat After Me, Stocks Are Not an Effective Inflation Hedge | Financial PostAdvertisement oop
Story continues below
This advertisement has not loaded yet, but your article continues below.
Skip to Content Subscribe $0.50/week
Advertisement 1
This advertisement has not loaded yet, but your article continues below.
Source: Bank of America Bloomberg
Article content<br>(Bloomberg) — Surveys indicate that investors are piling into stocks even as they see rising inflation. That’s likely to backfire as equities aren’t the hedge against price growth they are often taken to be.
Sign In or Create an Account<br>Email Address<br>Continue<br>or
View more offers
Article content<br>It’s time to pay much more attention to real quantities again. Inflation is resurgent as the energy shock ripples through the global economy. Investors are rightly concerned: the net percentage of respondents in Bank of America’s Fund Manager Survey expecting higher inflation is back at its highest level since the pandemic.
Article content
We apologize, but this video has failed to load.<br>Try refreshing your browser, or<br>tap here to see other videos from our team.
Article content
Article content<br>Yet the very same survey showed a record monthly jump in equity allocation among fund managers, going back over 25 years. The two are incompatible.
Article content
Top Stories<br>Get the latest headlines, breaking news and columns.
There was an error, please provide a valid email address.
Sign UpBy signing up you consent to receive the above newsletter from Postmedia Network Inc.
Thanks for signing up!<br>A welcome email is on its way. If you don't see it, please check your junk folder.<br>The next issue of Top Stories will soon be in your inbox.
We encountered an issue signing you up. Please try again
Interested in more newsletters? Browse here.
Article content<br>Equities are real assets. Corporate revenues and earnings are expected to rise with inflation, as stocks are claims on real productive assets such as intellectual property, land, factories, etc. That’s why equities are typically seen as an inflation hedge.
Article content<br>But this neglects one crucial feature: duration. All financial assets have some sort of duration, the average time taken to receive future cash flows, weighted by their present values.
Article content<br>Stocks have the highest duration. They are effectively a call option on the solvency of a firm in perpetuity. Cash flows are thus expected long into the future, but as the discounting rate is assumed to be larger than the long-run growth rate on income streams, they sum to a finite value, what is taken to be the fair value of the stock.
Article content<br>That’s all good and well, but there is a problem the theory doesn’t account for: when inflation is elevated, investors don’t want duration. Indeed they repudiate it.
Article content
Article content<br>Why? The higher duration of an asset, the longer you must wait to reinvest your outlay at a new coupon rate. Take a regular bond for example. It has a finite maturity after which you get your principal back and can negotiate a higher coupon if inflation has risen.
Article content<br>With stocks, however, you are locked in. The coupon is effectively the return on equity, which is fairly steady over the long term. With no tendency for the ROE to rerate, and no opportunity to renegotiate the coupon, stocks become a shunned asset when inflation is high.
Article content<br>This is exactly what happened in the Great Inflation of the 1970s. Nobody wanted to hold equities, a period associated with the infamous “Death of Equities” BusinessWeek front cover in 1979.
Article content<br>Stocks’ performance in real and nominal terms was eviscerated in that decade as investors, rather than seeing them as an inflation hedge, began to view them only as a surefire way to ruin.
Article content<br>Stocks were in fact the worst performing asset through the 1970s. Treasuries and corporate debt, which are reflexively considered poor choices to hold when inflation is rampant, suddenly had the desirable property that one’s money would soon be returned and could be reinvested at a better rate, a luxury not afforded to stockholders.
Advertisement 1
This advertisement has not loaded yet.
Trending
Welcome to the most important oil town in Canada — population 623
Oil & Gas
Opinion: Trump wants higher drug prices in Canada. That might not be bad
FP Comment
Advertisement 1
Story continues below
This advertisement has not loaded yet, but your article continues below.
Canadians can now get digital prescriptions for 'generic Ozempic'
Retail & Marketing
William Watson: Trump chickens out on beef tariff cuts
FP Comment
Posthaste: Trump's loss is Canada's gain as Canadian tourists stay home
News
Advertisement 2
Advertisement
This advertisement has not loaded yet, but your article continues below.
Article content<br>It turns out that duration, not whether an asset is considered to be real or nominal, was a much...