There’s a lesson to be learned: inflation itself isn’t necessarily a problem for equities. If there is damage, it is more likely caused by central bankers trying to control it. Here’s an example:
Although the US CPI report attracted the bulk of the attention, there was a far more eye-popping inflation statistic released yesterday. Annual inflation in Argentina hit 98.8%. Yes, you’re reading that correctly – consumer prices have nearly doubled in the past year. Although Buenos Aires is one of my favorite places to visit, I confess that I don’t watch the daily goings on in Argentina’s stock market. In that timeframe, the S&P MERVAL Index, Argentina’s flagship, is up 188%! In USD terms, it is up just under 60%. I must admit to more than a little non-buyer’s remorse about missing a move like that!
But it’s not only markets experiencing hyperinflation that are leading the pack. Something similar is occurring in a market that I follow closely. UK CPI on a year-on-year basis came in at a better-than-expected 10.1%, helped by a month-on-month drop of -0.6%, which was bigger than the -0.4% that was expected. We can make a case for UK disinflation after a result like that, which can explain the notion that the FTSE100 (UKX) is up about 0.5% in spite of a nearly 10% drop in Barclays (BARC, BCS). But one solid inflation report can’t explain why the FTSE crossed the 8,000 level for the first time ever this morning. The index has been putting in a series of new highs this year, up 7.3% year-to-date. That said its one-year performance of +5% is about 12.75 percentage points better than the S&P 500 (SPX). The buyer’s remorse dims for US investors, however, since the FTSE’s -6.9% in USD terms is roughly on par with SPX’s -7.75% on a 1-year basis.
Why would the assertion we made in the opening sentences be the case? Remember that in theory, if not always in practice, hard assets tend to be good hedges against inflation. Companies have assets that generate returns. Those could be valuable brands with international recognition, natural resources, or services with relatively inelastic demand. If inflation is raising prices across the economy, those assets become more expensive to replace. If a company is asset-rich, inflation can boost its value. If a company’s goods or service are in sufficient demand that they can pass along higher prices to their consumers, that is of high value as well. And if inflation causes a company’s home currency to depreciate relative to those of its export customers, that can have a positive impact on its bottom line.
The difficulty arises when central banks turn their focus to fighting inflation. A classic definition of inflation is too much money chasing too few goods. If we extend “goods” to mean assets, then it’s easy to see how accommodative monetary policies can lead to inflation, and how that inflation can extend to risk assets. One of the most amazing features of the post-Global Financial Crisis era was that we experienced nearly unabated monetary accommodation without much inflation in goods and services, even though there was plenty of inflation in asset prices. As a result, central banks could maintain low interest rates and expand their balance sheets when necessary.
But over the past year or so, things changed. A wide range of factors, not least of which was an unprecedented level of monetary accommodation, led to “real-world” inflation: goods, services, wages, etc. That pushed the Fed and many of its peers off the sidelines, raising rates and either holding their balance sheets steady or shrinking them outright. By making money more expensive and less plentiful, it should restrain prices. So far in the US we have seen more restraint in asset prices than “real-world” prices, so the Fed remains in a tightening stance. On a relative basis though, Europe and the UK have more accommodative central banks than the US. The Bank of England just raised rates to 4%, and the ECB raised to 3%, both below the Fed’s 4.75%. Their fight against inflation is less aggressive than the Fed, which goes some way to explaining the outperformance of European markets versus the US.
Does this mean we should root for inflation? I say no. There are too many pernicious problems that can result from an economy that has deep-rooted inflation. But in the intermediate-term, inflation is not in itself an equity-killer. The side effects from the economic medicine can themselves be the problem.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.
