Lex S&P500

Investors with only moderately addled memories will remember chatter common to the rallies in the late-nineties and mid-noughties. Many said loose monetary policy was no longer transmitting itself into higher wages and consumer prices. Rather, inflation was appearing in asset classes such as equities and property.

Of course, this confuses monetary phenomena with bubbles. But do not be surprised if similar arguments return now that low interest rates are coinciding with rampant equity markets and the odd sign of life in housing. A far worse sin, however, would be if investors reversed the causality and were buying equities as an inflation hedge. This is oft-heard advice. In theory at least, provided that companies can pass higher prices on to their customers, valuations should be indifferent to inflation because real future cash flows should be discounted at a real interest rate.

Indeed, contrary to both common wisdom and theory, the truth is stock valuations actually suffer during periods of rising prices. Over the past 20 years, the rate of inflation has shown a strong negative relationship with the S&P 500 price/earnings ratio, according to UBS. And it is not a case of lower valuations, share prices actually fall, particularly in the short and medium term (10 years). Over longer periods, however, academics such as Ali Anari and James Kolari show equities to be a better hedge against inflation. Very simply, for example, US shares have averaged a long-term total return of about 9 per cent, whereas inflation has averaged only 4 per cent.

Just why over shorter periods valuations tumble as prices rise divides economists. Suffice to say they do. Those piling into equities today worried about inflation tomorrow, therefore, could be in for a shock. If, for example, the forward p/e ratio of the S&P 500 falls 2 points, earnings would have to be an extra 19 per cent higher next year to compensate. That would be some headwind in today’s environment.

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