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.

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