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Economy & Markets 07–08/2004
Inflation and equity prices
One of the most important questions that arises in the assessment of equity markets is the correlation between stock prices and inflation. It is commonly believed that rising prices also push up corporate profits and hence share prices. But is this fact or fiction?
AUTHOR: DR. FRANK BULTHAUPT Tel.:+49.69.2 63-37 95 email@example.com
To evaluate the impact of inflation on stock market performance, investors frequently draw on experiences in the immediate aftermath of the two World Wars. In Europe, these periods were marked by drastic currency depreciation. However, stockholders at the time were far less affected by inflation and currency reforms than were (for example) holders of fixed-income securities or cash, some of whom lost all of the money they had put up. Are stockholders, then, protected against inflationary risks? At first sight, economic logic suggests that they might be. After all, rising prices mean higher corporate sales revenues and – provided costs do not rise even more sharply – higher profits. It is often pointed out in this context that a share is based on an underlying physical capital stock, which is a real entity and has a value that cannot be eroded by inflation. The nominal value of the company should, therefore, rise in line with general price rises. In short, this would mean for the present line of argument: Given that shares refer to real capital and the (real) earnings opportunities derived from it, price rises should drive up both earnings per share and share prices in equal measure. In this case both future dividend payments and share prices – in other words the “redemption value” – would be inflation-proof as a result of the adjustments to price inflation. However, past experience shows that this is not always the case, and it is therefore worth taking a critical look at this argument. No one would deny that, over very long horizons (e.g. about one hundred years), there is a high degree of correlation between price indices on the one hand and profits and stock indices on the other, i.e. that they move in line with each other. However, the situation can be quite different over the short and medium term (e.g. within a ten-year period). In fact, the violent economic fluctuations of the seventies, eighties and nineties were accompanied by an inverse relationship between inflation rates and stock market performance. This article sets out to examine the relationship between inflation and share prices systematically, focusing on the following stages: the impact of inflation first on corporate profit margins and profits per unit, second on economic growth, and third on the risk premium for shares.
Generally speaking.07 0. an inflationary economy forfeits growth potential.05 8 85 6 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 5 4 3 2 1 0 -1 Profit margin Inflation Inflation hurts unit profits 0. There are several explanations for this.12 0. consumers tend to spend more time comparing prices and searching for alternative offers. real economic growth slows by around 0. In reality. Inflation sands up the engine of an efficiently operating economy. The second explanation points to the behavior of central banks. Caporin and C. not monthly.J.1) According to our own estimates based on annual values from 1950 onwards. can be estimated at twice that amount. a one percentage point rise in the rate of inflation trims growth in both capital productivity and labor productivity by 0. and restricts the ability to pass on cost rises through higher prices. However. a restrictive monetary policy squeezes corporate sales potential. 2002. Furthermore. inflation would arguably not affect corporate profit margins (the ratio of profits per unit to unit costs). With a one point acceleration in inflation. but rather in stages. the empirical evidence of recent decades clearly contradicts this theory (see adjacent chart). Instead. inflation affects market participants’ economic activities. In this kind of environment creditors demand risk premiums – with all the consequences this has for the cost of capital. And finally. which in turn means lower profit margins. are exposed to the risk that one of the parties to the agreement might inadvertently be placed at a disadvantage. This requires extra resources. pensions and pay settlements. GRETA Working Paper 02. Applied Economics. In an inflationary environment.Economy & Markets 07–08/2004 I N F L AT I O N A N D E Q U I T Y P R I C E S INFLATION AND CORPORATE PROFIT MARGINS If businesses were simply able to pass on higher costs in their output prices. Long-term contracts. 24) and M. due chiefly to the drain on household purchasing power. Smyth (Inflation and the growth rate in the United States’ natural output.14 0. rhs) 12 10 8 6 4 2 0 INFLATION AND ECONOMIC GROWTH When inflation is rising. Companies that put up their prices thus run the risk of quickly losing market share. the correlation between inflation and profit margins seems to be negative. this impacts on the overall economic development in a number of ways.4 percentage points.09). which may make sense from the individual’s point of view but which are nonetheless misplaced in macroeconomic terms. cost increases tend not to be passed on immediately in full.25 to 0. If they respond to inflationary processes by tightening monetary policy. 1992. Econometric analysis further demonstrates that the higher the rate of price increases. in other words. Market players become less willing to commit to long-term contracts. This means that options designed to put resources to efficient economic use – options which are pursued in periods of low inflation – are not exploited.02 1974 1979 1984 1989 1994 1999 2004 Unit profits of US nonfinancial sector US consumer inflation (y-o-y) (NA. the more powerfully inflation acts as a brake on growth.04 0. When inflation is rising. Empirical research underscores the negative influence of inflation on both productivity growth and economic expansion. Furthermore. 1) Inflation hurts economic growth 16 12 8 4 0 -4 1974 1979 1984 1989 1994 1999 US economic growht US inflation (CPI) The following analyses are based on work by D.06 0.15 0. structural changes also put pressure on profit margins: businesses have to take account of consumer reactions in their pricing policy. The simplest points to the time lags between changes in costs and adjustments to prices. It generates risks for nominal contracts such as loans. The short-term economic effect.08 0. They therefore prefer to adopt a more cautious price policy.2 percentage points per year. such as investment financing or collective pay agreements which run for a number of years. a spurt in inflation from 2 % to 3 % has a substantially lower impact than a step-up from 5 % to 6 %. Consequently. Inflation hurts profit margins 0. they plan and act in shorter timescales.09 0.13 0. businesses alter their sales prices once or twice a year at the most.10 0.11 0. 29 . this translates into falling profits per unit. Di Maria (Inflation and Growth: Some panel data evidence.
the cumulative effects can certainly assume substantial dimensions over the years. a 0.4 0. for example. the closer the correlation between the level of inflation and fluctuations in inflation. Markets could come to terms with the regular price increases and factor them into their planning in a timely fashion. As a result. the one-year intervals between 1950 and 2003. However. Ball and St.8 0. 3.2 % deceleration in the rate of real earnings growth causes the stock’s fair value to drop by roughly 5 %. inflation can impact on both profit margins and real economic growth through various channels.4 0. All told. Applying the so-called Gordon model. These fluctuations in inflation are closely related to the level of inflation. High inflation rates carry high inflation risk 0. for example. The longer the period examined. It depicts the relationship.7. which factors cumulative future earnings flows into share valuation. The following empirical results remain valid even if the GDP deflator is used to calculate the inflation rate.. A low average inflation rate is accompanied by marginal fluctuations in inflation. we find a positive correlation of around 0. with consequences for the fundamentally justified share price.2 0 1 3 5 7 9 11 13 15 17 19 30 . instead of the consumer price index. 2. 4) Applying. whereas strong shifts in inflation are to be found in an environment of high inflation rates. However. at the following four quarters. who would be able to anticipate it. 5) Formally speaking we are dealing with the correlation between the rate of inflation at any point in time t.2) INFLATION STOKES INFLATION UNCERTAINTY Were inflation to remain constant over many years.2 % per annum – as shown in the analysis – may not appear particularly remarkable. und (infl(t)-infl(t+n))^2.SPECIAL FOCUS Economy & Markets 07–08/2004 Although such analyses can provide information only about specific periods and specific patterns of economic policy response.. . with a reading of less than 0. Viewed in isolation.2 0.3 0.6 0. Brooking Papers on Economic Activity 1. inflation curtails corporate profits and earnings per share. 20 quarters. it would not give rise to any particular concern among market players.1 0 1 2 3 4 5 6 This link can be traced more precisely with reference to the two adjacent charts. the link between the rate of inflation and the subsequent change in inflation is still comparatively tenuous. for the entire period from 1950 to the end of 2003. a decrease in economic growth by around 0.5) These calculations underpin the close connection between the level of inflation and longer-range inflation uncertainty.6 0.2 between the resultant 53 inflation means and inflation variances. with a transition to three-year periods the link between the resultant inflation means and variances becomes closer: the correlation coefficient climbs to almost 0. 1990 4) The correlation has been calculated for non-overlapping periods. however. 3) The following analyses are based on work by L. inflation is prone to marked fluctuation over time.. Looking. they do underscore the ways in which the stock market potentially reacts. 3) The upper chart depicts the correlation between the level of inflation (more precisely: the mean value of inflation rates) and inflation uncertainty (more precisely: variance in inflation around the mean value) for time intervals of varying length. infl(t). although positive. between the current level of inflation and its change in 1. Ceccetti (Inflation and Uncertainty at Short and Long Horizons. 2) Increasing correlation between inflation rate an inflation risk over time 0. This significant connection between the level of inflation and inflation uncertainty is illuminated from another angle by the next chart. As we all know. while demand shocks lessen it.2 the correlation coefficient is not particularly These results could be refined further by distinguishing between so-called supply shocks (such as productivity changes or oil price increases) and demand shocks (growth in demand fueled by extremely expansive monetary policy or a sudden surge in demand from abroad): supply shocks heighten the negative correlation between inflation and equity prices.5 0.7 0.
Bodic (Common Stocks as a Hedge Against Inflation. On the other. Equities were not a hedge against inflation during that period.1993). US real yield (10yr) Inflation drives wedge between P/E ratio and real yield 16 12 8 4 0 -4 1974 1983 Real earnings-yiled gap 1992 2001 Inflation rate The notion that equities provide a hedge against inflation was widespread in the older literature on economics. The adjacent chart illustrates the negative correlation between inflation and share performance since the beginning of the seventies. on closer examination it is clearly apparent that variances between the (inverse) P/E ratio and real yields increase in parallel with the rate of inflation. inflation is low. THE OUTCOME: INFLATION DEPRESSES EQUITY PERFORMANCE Medium-term correlation between share performance and inflation average change (y-o-y) over three years 40 30 20 10 0 -10 -20 1974 1979 1984 1989 1994 1999 2004 S&P 500 US inflation rate 12 10 8 6 4 2 0 On balance. In the meantime. the more a real yield-P/E comparison overstates the fair value. the correlation moves up appreciably to levels of more than 0. the authors conclude that inflation and (rolling) five-year returns move broadly in parallel. which argues that. the danger of overvaluation therefore increases with the pace of inflation. Although a close correlation has emerged in the past two decades between the P/E ratio and the real yield. 1983 Inverse P/E ratio 1992 2001 Markets evidently price this danger into share quotations. the investor must expect high fluctuations in inflation over the following two to five years. the yield on a particular share can. international comparative studies show that stock prices can benefit from inflation as soon as the inflation rate rises above around 15 percent. future dividend payments and stock prices would be inflation-proof. the empirical evidence suggests that the level of fluctuation in the inflation rate will also be low over the following years. inflation affects share performance in different ways. On top of this. fundamentals such as earnings per share are hit. the negative impact of inflation on stock performance is widely recognized in the empirical literature. 6) 31 . Journal of Finance 31). rising inflation and its impact on profit margins and sales markets can have a dampening effect on real profit growth. 7) This is the conclusion reached using the Gordon approach. there is a flight to material assets in times of hyperinflation. looking 8 to 20 quarters ahead. however. Using this valuation approach. therefore. a 5 % rise in prices (for example) would lead to an equivalent rise in corporate profits.Economy & Markets 07–08/2004 I N F L AT I O N A N D E Q U I T Y P R I C E S convincing. placing a damper on performance. However. where inflation has a negative effect neither on real profit growth nor on risk premiums. An exception to this is the article by Boudoukh and Richardson: Stock Returns and Inflation: A Long-Horizon Perspective (American Economic Review 83. Looking at the unusually long horizon of the years 1802-1990. P/E ratio and real yield 16 12 8 4 0 -4 1974 In the real world.7) The higher the inflation rate. on the other hand. 6) THE CONSEQUENCES FOR SHARE VALUATION: REAL OR NOMINAL YIELD? In an ideal world. If. Furthermore. On the one hand. dividend payments and stock prices. as an inverse P/E ratio. investors demand risk premiums for shares in an inflationary environment. In that case. To find a fair value in such a case. the longerterm inflationary uncertainty also pushes up the risk premium for shares. and shares would then function like an inflation-indexed bond. be compared with the real yield on a bond. Clearly. Both of these effects reduce the fair value of the share. the inverse P/E ratio will correspond to the sum of the real return and the risk premium minus the average (real) profit growth rate per share. justified doubts regarding the thesis were expressed as long ago as 1976 in an article by Z. and thus on the average profit growth rate. if a stock is fairly valued. By contrast.7 In other words: if the inflation rate is high at the time of investment.
8) Moreover. to combine the inflation rate and the real yield. Working on the hypothesis. this idea looks attractive.SPECIAL FOCUS Economy & Markets 07–08/2004 P/E ratio. that neither the share price nor the dividend payment are correlated with the rate of inflation and that – because of high price volatility on the stock market – price fluctuations tend to take place randomly. real and nominal yield 14 10 6 2 -2 -6 1961 1967 1973 1979 1985 1991 1997 2003 Real earnings-yield gap Nominal earnings-yield gap P/E ratio. 32 . for an investment decision of up to one year. real and nominal yield P/E ratio on basis of earnings estimates for following 12 months Should this observation lead us. a comparison of share and bond yields simply becomes a comparison of the (inverse) P/E ratio and the nominal return. then. From a theoretical point of view this valuation approach is appropriate in the short run. This arbitrage concept underlies what has become known as the “Fed model”. in comparison to the real yield approach it clearly proves to be the more stable rule of thumb. 16 12 8 4 0 -4 1979 1985 Real earnings-yield gap Nominal earnings-yield gap 1991 1997 2003 8) This arbitrage approach is based on a general random walk property (martingale) of shares. and to use the resulting nominal yield as a yardstick for the fair value of a share? Is a P/E-nominal yield comparison the correct tool for valuing shares? At first sight.
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