Surveys indicate that investors are piling into stocks even as they see rising inflation. That’s likely to backfire as equities aren’t the hedge against price growth they are often taken to be.
It’s time to pay much more attention to real quantities again. Inflation is resurgent as the energy shock ripples through the global economy. Investors are rightly concerned: the net percentage of respondents in Bank of America’s Fund Manager Survey expecting higher inflation is back at its highest level since the pandemic.
Yet the very same survey showed a record monthly jump in equity allocation among fund managers, going back over 25 years. The two are incompatible.
Equities are real assets. Corporate revenues and earnings are expected to rise with inflation, as stocks are claims on real productive assets such as intellectual property, land, factories, etc. That’s why equities are typically seen as an inflation hedge.
But this neglects one crucial feature: duration. All financial assets have some sort of duration, the average time taken to receive future cash flows, weighted by their present values.
Stocks have the highest duration. They are effectively a call option on the solvency of a firm in perpetuity. Cash flows are thus expected long into the future, but as the discounting rate is assumed to be larger than the long-run growth rate on income streams, they sum to a finite value, what is taken to be the fair value of the stock.
That’s all good and well, but there is a problem the theory doesn’t account for: when inflation is elevated, investors don’t want duration. Indeed they repudiate it.
Why? The higher duration of an asset, the longer you must wait to reinvest your outlay at a new coupon rate. Take a regular bond for example. It has a finite maturity after which you get your principal back and can negotiate a higher coupon if inflation has risen.
With stocks, however, you are locked in. The coupon is effectively the return on equity, which is fairly steady over the long term. With no tendency for the ROE to rerate, and no opportunity to renegotiate the coupon, stocks become a shunned asset when inflation is high.
This is exactly what happened in the Great Inflation of the 1970s. Nobody wanted to hold equities, a period associated with the infamous “Death of Equities” BusinessWeek front cover in 1979.
Stocks’ performance in real and nominal terms was eviscerated in that decade as investors, rather than seeing them as an inflation hedge, began to view them only as a surefire way to ruin.
Stocks were in fact the worst performing asset through the 1970s. Treasuries and corporate debt, which are reflexively considered poor choices to hold when inflation is rampant, suddenly had the desirable property that one’s money would soon be returned and could be reinvested at a better rate, a luxury not afforded to stockholders.
It turns out that duration, not whether an asset is considered to be real or nominal, was a much better predictor of performance in that decade.
Stocks had the highest duration of the main asset classes in the 70s, approximating duration by the inverse of the dividend yield. That’s followed by Treasuries, which fared better than stocks but still delivered a negative real return, and then corporate bonds, the next worst performing asset class. (I have not included TIPS as their duration mechanically rises and falls with inflation.)
Spot commodities, with no cash flows, have effectively zero duration. They were also by far and away the best performing asset class in the 1970s, along with other real assets and equity sectors with low duration such as energy (see below).
The erroneous argument that stocks keep track with high inflation rests on the assumption their earnings do so too, as discussed. But if stocks become in greater competition with other, lower-duration assets, they will reprice until they become sufficiently attractive again.
This is what happened in the 1970s. Stocks bottomed in price terms in 1974, but the P/E multiple they offered carried on cheapening into the early 80s as the inflation-boosted rise in E couldn’t outperform the change in P, as investors shunned equity duration.
It looks even worse today for the stock market. Not only do equities still have the highest duration among assets, it is even higher, mushrooming to a level only pipped at the peak of the tech bubble in 2000.
The main culprit is the tech sector. It and other high-growth sectors have large expected cash flows relatively far into the future, inflating their durations.
Tech has the largest duration, followed by consumer discretionary and telcos, while utilities and energy have the lowest duration.
All through this decade, investors have been adding to their duration exposure, if we look at the steady and almost uninterrupted ascent of duration-weighted flows into sector ETFs.
But that is now a glaring vulnerability for the market. An overbought market and its most overbought sector are laden with duration when we are coming into a period of renewed inflation, as anticipated by a surfeit of leading indicators.
The hope among tech bulls is that the productivity revolution unleashed by AI will also neuter price pressures. But that relies on disinflation arriving at the same time as the inflation, and that job losses won’t lead to a further rise in a fiscal deficit that is already very conducive to higher prices.
It’s possible the belief that stocks are a good inflation hedge could carry them some way. But it won’t take long for fundamentals to catch up as investors remember why owning duration when there’s inflation is a very bad idea.
The MacroScope column is a wide-angled take on the most important macro and market topics, rising above the short-term noise to get the big picture
Simon White is a macro strategist who writes for Bloomberg. The observations he makes are his own and not intended as investment advice.
Written by: Simon White @Bloomberg
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