Inflation has been a big concern this year, but why should it matter for growth assets like stocks and real estate? Surely profits and rents will increase with higher inflation offsetting any negative impact of higher interest rates due to higher inflation? In reality, it is more complicated. Our note two weeks ago looked at the outlook for inflation – why the current peak is likely to prove transitory, but more broadly why the long-term decline in inflation over the past 40 or so years may be over ( see Inflation Q&A). This note takes a closer look at the impact of inflation on growth assets such as stocks and real estate.
What drives ROI?
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 earnings or rents and changes in valuations. So: Yield = Income Yield + Earnings Growth + Valuation Change
The first two parts are quite obvious and less interesting:
- Income yield is simply the stream of income produced by the asset – whether dividends in the case of stocks or property rentals. It tends to be relatively stable over time.
- The second is the growth rate of investment income (or rents in the case of real estate).
- The third component is the portion of return due to valuation changes, which is essentially the rise or fall of the asset price relative to earnings growth, causing multiples to rise or fall. from price to earnings in the case of stocks.
Cash, government bonds and inflation
For cash and bank deposits, income yield (or interest rate) is what matters and to the extent that higher inflation leads to higher interest rates, investors in these assets can be protected . However, just note that interest rates tend to lag big moves in inflation, so in the mid-1970s interest rates rose but not as fast as inflation (because banks central banks and investors were slow to realize that inflation would remain high), which meant that investors fell back in real terms. They only rose when rates topped in the early 1980s and then inflation fell.
Source: RBA, Bloomberg, AMP Capital
For investors in government bonds, there is no earnings growth and they incur a capital loss when yields rise with inflation (i.e. the change in the valuation component becomes negative). Ultimately, bond investors benefit from higher yields once they roll over their investments into the higher yields, but in the meantime, they are unprotected. Inflation-linked bonds offering an inflation-linked return are the best protection for bond investors.
Changes in PEs have a big impact on stock returns
For equities and other growth assets, an important factor in the impact of changes in inflation comes from changes in the price-to-earnings ratio (or price-to-rent ratios for real estate). Price/earnings multiples can be volatile in the short term as the equity market anticipates swings in earnings and due to shifts in sentiment. But they can also be subject to longer-term or secular fluctuations. The following chart shows the contribution to rolling 10-year US equity returns from dividends, earnings and changes in valuations (or PE).
Source: Bloomberg, AMP Capital
And here it is for Australia, albeit for a shorter period because the PE series for Australia doesn’t go as far back as it does in the US.
Source: Bloomberg, AMP Capital
Changing valuations or PEs (the green part) boosted US stock market returns significantly in the 1960s (as PEs rose) and then became a big drag in the 1970s (almost all contribution to earnings return being offset by declining PEs), but became a large positive (often operating at 5% per annum or more) from the early 1980s to the 2000s and even recently (with increasing PEs) . Several factors had an impact on 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 a big factor was inflation going from low in the 1960s to high in the 1970s (pushing the PEs down) and then back again from the 1980s (pushing the PE up).
Inflation and PE
The following chart shows the long-term relationship between US inflation and the US price-earnings ratio. The PE tends to fall when inflation rises (as happened in the 1970s) and it rises when inflation falls (as has happened in the period since the early 1980s) , although this is less clear once inflation falls into deflation. Oddly enough, it seems that the market’s preferred inflation rate is the same as the Fed’s, around 2%!
Source: Bloomberg, AMP Capital
The following graph shows the same relationship for Australia although it only goes 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 PEs and inflation:
- First, low inflation means lower interest rates, which increase the value of future earnings and dividends, making stocks more attractive. Or, put another way, lower inflation and interest rates make higher-yielding assets more attractive, so investors gravitate toward those assets that drive up their price relative to their earnings, dividends or rents and therefore their yield decreases.
- Second, low inflation means reduced economic volatility and uncertainty, so investors are willing 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 actual earnings. Again, investors are willing to pay more for stocks when inflation is low.
Of course, if inflation turns into deflation, it can be bad insofar as it is associated with economic contraction. But assuming deflation is avoided, the bottom line is that a move from high inflation to low inflation leads to higher PEs (and lower yields), and vice versa for a move from low inflation to high inflation.
The bottom line
The bottom line is that equity market returns have been boosted since the early 1980s as PE multiples rose (or earnings yields fell) due to the downward trend in inflation. over the past 40 years. This phenomenon 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 seen below – especially for residential real estate.
Source: REIA, JLL, Bloomberg, AMP Capital
Thus, if inflation rises sharply in the coming years, this could begin to reverse the impulse in growth asset returns seen since the early 1980s, with investors demanding lower price-to-earnings ratios and price ratios /Lower rents (or higher yields).
As we discussed in the Inflation Q&A, inflation is expected to rise further over the next few months, which could push bond yields higher and threaten equity valuations (especially high PE stocks, like technology), but the rise in inflation being driven by base effects and the bottlenecks associated with the pandemic and its reopening should be transitory. However, in a longer-term context, we are likely seeing a bottom in inflation and long-term bond yields after a 40-year downtrend. This will mean that the tailwinds that helped propel growth assets higher – lower inflation driving ever lower yields and higher PEs, which in turn meant higher yields than would imply the only increases in earnings and rents – will begin to fade, leading to returns more limited to underlying yields and earnings/rental growth. Inflation around central bank targets is the best case scenario as it would still mean low inflation – but less risk of deflation and likely higher wage growth and investment returns would still be acceptable. The risk would be that if inflation slips back out of control in a sustained manner, the increase in valuation due to low inflation will be reversed, resulting in low returns on growth assets. This is not our base case given that central banks are always focused on inflation targets and technological innovation will put some brake on inflation, but it is a risk.