With rising inflation expectations hitting fixed income markets, a common assumption is that this should be good news for equities. The reality is more nuanced, writes Giles Parkinson.

 

Despite quantitative easing on an unprecedented scale and a raft of other accommodative monetary policy measures, central banks in the developed world have struggled to meet their inflation targets in the post-financial crisis period.

By contrast, US president-elect Donald Trump has in a matter of weeks succeeded in generating some inflation, or perhaps more accurately, generating higher inflation expectations. The US breakeven inflation rate – the yield difference between Treasury Inflation Protected Securities and regular Treasury bonds – implies that inflation in America will average two per cent over the next decade; the highest level since the autumn of 2014.  

Inflationary expectations are driven in no small part by a shift in emphasis towards fiscal policy, which will likely be a key pillar of Mr Trump’s presidency. Tax cuts, increased infrastructure spending, overseas cash repatriation and defence programmes are all on his to-do list once in office.

Equity strategists have studied the market price movements, considered the coming inflation and crafted a narrative; one in which investors should buy stocks, particularly banks and industrials, and shun more predictable ‘bond proxies’ such as utilities and consumer staples. There is an alternative, entirely plausible, scenario, however; which sees the return of inflation as a potential danger to all equities. In this scenario, less capital intensive industries such as consumer products look best equipped to provide a relative haven for long-term investors.

Real return

In principle, the strategists are right. Equities represent a claim on the future productive potential of real assets. Pull up the domestic price index of an inflationary emerging economy today or open the history books and it will be evident that shares tend to retain their real value. But past experience shows how uncomfortable the journey can be. As a result of the hyperinflation experienced in Germany during the interwar Weimar Republic, Daimler’s stock price sank as low as 94 of its cars before rebounding. The purchasing power of sovereign bonds, in contrast, was eviscerated even as the Republic faithfully honoured its obligations.

Therein lays the paradoxical allure of equities. In the short-run, their price volatility makes them riskier than bonds, but to the long-term saver they have historically outperformed. Nevertheless, most companies struggle to maintain a constant real return on real capital invested when inflation goes up because the accounting book lags inflation. The cost of goods sold is based on the price paid for raw materials last year, not what they cost today. Capital assets are depreciated from their purchase price decades ago, not what it costs to maintain them now. Nominal revenues and profits increase, but their real worth declines. Tax is then levied on these inflated reported profits, further suppressing after-tax cash flow.

Consequently, earnings – never a perfect proxy for free cash flow at the best of times – become increasingly unreliable in a period of rising inflation. It stands to reason that companies with lower capital intensity and higher margins should fare relatively better, particularly if they have pricing power in charging for their products and services.

History lesson

The inflationary experience of the 1970s was so painful that in the early 1980s several companies published supplementary accounts restated for the inflationary effects. The below table looks at four such annual reports, compares the two versions of the accounts, and states what the price-earnings multiple would have been on each basis.

Looking at the numbers, it is clear that capital-heavy Exxon and Alcoa were not the value stocks.  While the reported figures were flattered by inflation, stripping this distortion away reveals that capital-light Colgate and Pfizer traded on far lower multiples.

Banking – one of the most capital-intensive industries – was also not immune. Wells Fargo’s return on equity remained constant throughout the 1970s and 1980s, even during years when inflation rose.  As a result, its real return on equity fluctuated wildly, turning negative at times.

Loans and deposits were marked higher during inflationary years, but the equity required to fund them did not. Therefore, a proportion of the annual ‘profit’ had to be diverted to equity each year to keep leverage constant. This charge did not go through the income statement, but nevertheless was a real cost to shareholders.

This perspective is particularly pertinent at the current market juncture. In recent weeks, bond yields have risen sharply and the stocks of cyclical, more economically-sensitive companies have fared dramatically better than ‘bond proxies’. The SPDR S&P Bank ETF is up 18 per cent since Trump’s election, whilst the Utilities ETF is down five per cent. 

Strategists claim this sector rotation has further to run. They would argue the present value of longer-dated cash flows are worth less in today’s money when discounted at a higher interest rate, with limited offsetting benefit from the improved economic growth those higher bond yields imply.

And yet, the increase in bond yields has been mostly caused by higher inflation expectations, not growth. If there is inflation ahead, investors are more likely to find relative safety in capital-light industries with pricing power, such as consumer products, software and pharmaceuticals, rather than banks and industrials.  Capital-intensive industries with long cash flow durations such as utilities look poorly-placed regardless of whether yields rise because of higher inflation or an improving growth outlook.

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