Why this is important for the investment markets – ShareCafe



Inflation has raised a lot of concerns this year, but why should it matter for growth assets like stocks and real estate? Surely incomes and rents will rise with higher inflation offsetting any negative impact of higher interest rates due to higher inflation? In reality, it is more complicated. Our memo from two weeks ago looked at the outlook for inflation – why the current peak should turn out to be transient, but more generally why the long-term decline in inflation over the past 40 years or so might be over ( see Inflation Questions and Answers). This note takes a closer look at the impact of inflation on growth assets like stocks and real estate.

What drives ROIs?

When considering the impact of inflation on investment returns, the best place to start is to consider what constitutes returns. The percentage return of an asset is determined by its income stream (or return) and capital growth, which can be broken down into growth in profits or rents and changes in valuation. So: Return = Return on Income + Growth in Profits + Change in Valuation
The first two parts are quite obvious and less interesting:

  • Return on income is simply the flow of income produced by the asset – whether it is dividends in the case of stocks or rents from property. It tends to be relatively stable over time.
  • The second is the rate of growth of investment income (or rents in the case of real estate).
  • The third component is the part of the return due to valuation changes, that is, essentially when the price of the asset increases more or less than the growth of profits, causing the multiples of the price to rise or fall. compared to profits in the case of equities.

Treasury and government bonds and inflation

For cash and bank deposits, the return on income (or interest rate) is what matters and to the extent that higher inflation results in higher interest rates, investors in these assets can be protected. However, just note that interest rates tend to lag behind large swings in inflation. Thus, in the mid-1970s, interest rates rose, but not as rapidly as inflation (because central banks and investors were slow to realize that inflation would remain high), which means that investors retreated in real terms. They only rose when rates broke their limits in the early 1980s, and then inflation fell.

Source: RBA, Bloomberg, AMP Capital

For investors in government bonds, there is no growth in earnings and they experience a capital loss when yields rise with inflation (i.e., the change in the valuation component becomes negative). Ultimately, bond investors enjoy higher returns once they roll over their investments into higher returns, but in the meantime they are not protected. Inflation-linked bonds offering an inflation-linked yield are the best protection for bond investors.

PE changes have a big impact on stock returns

For stocks and other growth assets, one of the main factors in the impact of changes in inflation comes from changes in the price / earnings ratio (or price / rent ratios for real estate). Price / earnings multiples can be volatile in the short term, as the stock market anticipates fluctuations in earnings and due to changes in sentiment. But they can also be subject to longer term or secular fluctuations. The following chart shows the contribution to the 10-year rolling stock market returns in the United States from dividends, earnings, and valuation changes (or PEs).

Source: Bloomberg, AMP Capital

And here is for Australia, albeit for a shorter period because the PE series for Australia does not go back as far as in the United States.

Source: Bloomberg, AMP Capital

The change in valuations or PEs (the green part) greatly boosted US stock market returns in the 1960s (when PEs rose), then it became a major drag in the 1970s (almost all of with the contribution to the return on earnings being offset by declining PEs), but became a big positive (often at 5% per year or more) from the early 1980s to the 2000s and even recently (with increasing PEs). Several factors impacted this including the optimism of the go-go years of the late 1960s, the supply revolution of the 1980s and the tech boom of the 1990s which were positive for PEs. But an important factor was the swing of inflation from a low in the 1960s to a high in the 1970s (which caused PEs to fall) and then back to low from the 1980s (which caused pushed PE upwards).

Inflation and PE

The following chart shows the long-term relationship between US inflation and the US price-to-earnings ratio. The PE tends to fall when inflation rises (as happened in the 1970s) and it rises when inflation falls (as has happened since the early 1980s), although this is less clear once inflation falls to deflation. Oddly enough, it looks like the market’s preferred inflation rate is the same as the Fed’s at around 2%!

Source: Bloomberg, AMP Capital

The following graph shows the same relationship for Australia, although it only dates back to 1962, as our PE data does not go back that far.

Source: ASX, Bloomberg, AMP Capital

There are three drivers of the inverse relationship between PE and inflation:

  • First, low inflation means lower interest rates, which increases the value of future earnings and dividends, which makes stocks more attractive. Or, put it simply, lower inflation and lower interest rates make higher-yielding assets more attractive, so that investors turn to those assets, causing their price to rise relative to their earnings, dividends or rents and therefore their yield decreases.
  • Second, low inflation means reduced economic volatility and uncertainty, so investors are prepared to price stocks at higher price / earnings multiples.
  • Finally, low inflation means improved earnings quality, as companies tend to underestimate depreciation when inflation is high and therefore overestimate real earnings. Again, investors are prepared to pay more for stocks when inflation is low.

Of course, if inflation becomes deflation, it can be bad to the extent that it is associated with an economic contraction. But assuming deflation is avoided, the bottom line is that a shift from high inflation to low inflation results in higher PEs (and lower yields), and vice versa for a shift from low inflation. to high inflation.

The bottom line

The bottom line is that stock market returns have been boosted since the early 1980s, when multiples of PEs have risen (or earnings yields have fallen) due to the downward trend in inflation over the years. over the past 40 years. This has also boosted the yields of other growth assets like real estate, which have also seen a significant rise in prices relative to rents, as evidenced by a sharp drop in rental yields as can be seen below, especially for residential real estate.

Source: REIA, JLL, Bloomberg, AMP Capital

So, if inflation rises sharply in the coming years, this could start to reverse the trend in growth asset returns observed since the early 1980s, with investors demanding lower price / earnings ratios and price / earnings ratios. lower rents (or higher returns).

As we have seen in the inflation Q&A, inflation is expected to rise further over the next few months, which could push bond yields higher and threaten the valuations of equities (particularly stocks of bonds). High PEs, like technology), but the rise in inflation being due to base effects and the bottlenecks associated with the pandemic and its reopening are expected to be transient. However, in a longer-term context, we are probably now seeing a trough in inflation and long-term bond yields after a 40-year downtrend. This will mean that the tailwind that helped propel growth assets higher – as lower inflation resulted in ever lower returns and higher PEs, which in turn meant higher returns than no would suggest the only increases in income and rents – will start to fade, resulting in returns more limited to the underlying returns and earnings / rent growth. Inflation around central bank targets is the best case scenario as that would still mean low inflation – but less risk of deflation and possibly higher wage growth and returns on investment would still be acceptable. The risk would be that if inflation got out of control on a lasting basis, the increase in valuation due to low inflation would reverse, resulting in low returns on growth assets. This is not our baseline scenario given that central banks are still focused on inflation targets and technological innovation will put some brake on inflation, but it is a risk.


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