Editor's letter

Equities are not a good inflation hedge

Institutional investors are definitely now worried about inflation. But they're not yet worried enough to flee to cash, says John Stepek

You can’t really escape from inflation right now. As we discuss in this week's magazine, the evidence now suggests that “inflation is definitely not transitory”. Energy prices are surging even as the government waffles on about ways to make heating our homes even more expensive and less efficient (anyone keen to swap their gas boiler for a heat pump? Thought not).

The latest obscure commodity that we’ve realised the supply chain can’t do without is magnesium. Turns out that it’s not only a key ingredient in the aluminium alloys necessary to make almost any car, but that the supply is almost entirely monopolised by China. Finally, we’re seeing an ongoing global labour shortage, which, as far as I’m aware, is something that no one had expected to see as a post-pandemic outcome. Forecasts of economic “scarring” and jobs shortages were far more common. 

So what are investors doing about it? The latest month survey of global fund managers from Bank of America is revealing. The world’s asset allocators are definitely now worried about inflation. The proportion who fear that inflation is “permanent” rather than “transitory” jumped from 28% in September to 38% this month. Meanwhile, they are more negative on bonds than they have been in the history of the survey (which goes back about 20 years – hardly a long view, but a decent period of time). This makes sense – investors know they don’t want to be in fixed-income assets if inflation, or worse still, interest rates are set to rise. 

However, investors aren’t yet bearish enough to flee to cash (for its optionality – it won’t necessarily protect you from inflation, but it gives you the chance to buy assets cheaper if they crash). Allocations to equities are still high by historic standards. Yet as Ruffer’s Duncan MacInnes recently pointed out on Citywire, equities don’t necessarily do a good job of protecting against inflation either. In fact, even equities with strong pricing power might struggle. Why? Because there are two key factors at play when it comes to equity valuations. One is earnings expectations. But the other is how much the market is willing to pay for those future earnings. 

During a period of inflation, a firm may well use its pricing power to preserve, or even grow earnings in real terms (ie, after inflation). Yet the price investors are willing to pay for those earnings may fall. MacInnes cites US confectioner Hershey’s during the 1970s. The firm grew real earnings per share by two thirds between 1972 and 1975. Yet over the same period the share price fell by as much as two thirds, because the instability associated with inflation saw investors demand a much higher risk premium for buying stocks, which meant the multiple (ie, the price/earnings, or p/e, ratio) they were willing to pay fell sharply. 

This makes sense. It also bodes ill for markets – US markets especially – because we’re starting with p/es at extreme highs compared with history. There are some places to hide – precious metals, commodity producers, certain financial stocks, certain emerging and frontier markets – but investors should be preparing for a very different backdrop to the one we’ve grown used to in the past decade. We’ll be discussing all of this at the MoneyWeek Wealth Summit on 25 November. Buy your ticket and learn more at moneyweekwealthsummit.co.uk.

Recommended

Will energy prices go down in 2023?
Personal finance

Will energy prices go down in 2023?

Wholesale gas prices are on a downward trajectory, but does this mean lower energy bills later this year?
27 Jan 2023
Best regular savings accounts – January 2023
Savings

Best regular savings accounts – January 2023

You can earn an attractive rate on the best regular savings accounts. We tell you the best on the market to take advantage of right now
27 Jan 2023
Equity release v downsizing – which is best?
Personal finance

Equity release v downsizing – which is best?

Equity release hit a record high in 2022. But is downsizing a better way to hold on to your money?
27 Jan 2023
Self-assessment tax returns: what you need to know about getting your tax bill right
Income tax

Self-assessment tax returns: what you need to know about getting your tax bill right

Understanding how self assessment works can help you ensure you pay the right amount of tax, as well as avoid penalties for missing the deadline.
27 Jan 2023

Most Popular

House prices could fall 30%. Should investors be worried about a repeat of 2008?
Investments

House prices could fall 30%. Should investors be worried about a repeat of 2008?

Some analysts are predicting that house prices could fall as much as 30%, which, when compared to the fact that prices have jumped 28% since April 201…
24 Jan 2023
When will interest rates go up?
UK Economy

When will interest rates go up?

New interest rates will be announced on 2 February – we look at what to expect.
26 Jan 2023
Is the State Pension triple lock doomed to fail?
Pensions

Is the State Pension triple lock doomed to fail?

The State Pension triple lock guarantees an increase in the state pension every year, but this assumes government income grows every year as well, whi…
25 Jan 2023