SPECIAL FOCUS

Economy & Markets 0708/2004

Inflation and equity prices

One of the most important questions that arises in the assessment of equity markets is the correlation between stock prices and inflation. It is commonly believed that rising prices also push up corporate profits and hence share prices. But is this fact or fiction?
AUTHOR: DR. FRANK BULTHAUPT Tel.:+49.69.2 63-37 95 frank.bulthaupt@dresdner-bank.com

To evaluate the impact of inflation on stock market performance, investors frequently draw on experiences in the immediate aftermath of the two World Wars. In Europe, these periods were marked by drastic currency depreciation. However, stockholders at the time were far less affected by inflation and currency reforms than were (for example) holders of fixed-income securities or cash, some of whom lost all of the money they had put up. Are stockholders, then, protected against inflationary risks? At first sight, economic logic suggests that they might be. After all, rising prices mean higher corporate sales revenues and provided costs do not rise even more sharply higher profits. It is often pointed out in this context that a share is based on an underlying physical capital stock, which is a real entity and has a value that cannot be eroded by inflation. The nominal value of the company should, therefore, rise in line with general price rises. In short, this would mean for the present line of argument: Given that shares refer to real capital and the (real) earnings opportunities derived from it, price rises should drive up both earnings per share and share prices in equal measure. In this case both future dividend payments and share prices in other words the redemption value would be inflation-proof as a result of the adjustments to price inflation. However, past experience shows that this is not always the case, and it is therefore worth taking a critical look at this argument. No one would deny that, over very long horizons (e.g. about one hundred years), there is a high degree of correlation between price indices on the one hand and profits and stock indices on the other, i.e. that they move in line with each other. However, the situation can be quite different over the short and medium term (e.g. within a ten-year period). In fact, the violent economic fluctuations of the seventies, eighties and nineties were accompanied by an inverse relationship between inflation rates and stock market performance. This article sets out to examine the relationship between inflation and share prices systematically, focusing on the following stages: the impact of inflation first on corporate profit margins and profits per unit, second on economic growth, and third on the risk premium for shares.

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INFLATION AND CORPORATE PROFIT MARGINS

If businesses were simply able to pass on higher costs in their output prices, inflation would arguably not affect corporate profit margins (the ratio of profits per unit to unit costs). However, the empirical evidence of recent decades clearly contradicts this theory (see adjacent chart). In reality, the correlation between inflation and profit margins seems to be negative. There are several explanations for this. The simplest points to the time lags between changes in costs and adjustments to prices. Generally speaking, businesses alter their sales prices once or twice a year at the most, not monthly. Furthermore, cost increases tend not to be passed on immediately in full, but rather in stages. The second explanation points to the behavior of central banks. If they respond to inflationary processes by tightening monetary policy, this impacts on the overall economic development in a number of ways, and restricts the ability to pass on cost rises through higher prices. And finally, structural changes also put pressure on profit margins: businesses have to take account of consumer reactions in their pricing policy. When inflation is rising, consumers tend to spend more time comparing prices and searching for alternative offers. Companies that put up their prices thus run the risk of quickly losing market share. They therefore prefer to adopt a more cautious price policy, which in turn means lower profit margins. In an inflationary environment, this translates into falling profits per unit.

Inflation hurts profit margins

0.15 0.13 0.11 0.09 0.07 0.05
8 85 6 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

5 4 3 2 1 0 -1
Profit margin Inflation

Inflation hurts unit profits

0.14 0.12 0.10 0.08 0.06 0.04 0.02

1974 1979 1984 1989 1994 1999 2004
Unit profits of US nonfinancial sector US consumer inflation (y-o-y) (NA, rhs)

12 10 8 6 4 2 0

INFLATION AND ECONOMIC GROWTH

When inflation is rising, a restrictive monetary policy squeezes corporate sales potential. Furthermore, inflation affects market participants economic activities. It generates risks for nominal contracts such as loans, pensions and pay settlements. Long-term contracts, such as investment financing or collective pay agreements which run for a number of years, are exposed to the risk that one of the parties to the agreement might inadvertently be placed at a disadvantage. In this kind of environment creditors demand risk premiums with all the consequences this has for the cost of capital. Market players become less willing to commit to long-term contracts. Instead, they plan and act in shorter timescales. This requires extra resources, which may make sense from the individuals point of view but which are nonetheless misplaced in macroeconomic terms. This means that options designed to put resources to efficient economic use options which are pursued in periods of low inflation are not exploited. Inflation sands up the engine of an efficiently operating economy; in other words, an inflationary economy forfeits growth potential. Empirical research underscores the negative influence of inflation on both productivity growth and economic expansion.1) According to our own estimates based on annual values from 1950 onwards, a one percentage point rise in the rate of inflation trims growth in both capital productivity and labor productivity by 0.25 to 0.4 percentage points. With a one point acceleration in inflation, real economic growth slows by around 0.2 percentage points per year. The short-term economic effect, due chiefly to the drain on household purchasing power, can be estimated at twice that amount. Econometric analysis further demonstrates that the higher the rate of price increases, the more powerfully inflation acts as a brake on growth. Consequently, a spurt in inflation from 2 % to 3 % has a substantially lower impact than a step-up from 5 % to 6 %.
1)

Inflation hurts economic growth

16 12 8 4 0 -4 1974 1979 1984 1989 1994 1999

US economic growht US inflation (CPI)

The following analyses are based on work by D.J. Smyth (Inflation and the growth rate in the United States natural output. Applied Economics, 1992, 24) and M. Caporin and C. Di Maria (Inflation and Growth: Some panel data evidence, 2002, GRETA Working Paper 02.09).

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Although such analyses can provide information only about specific periods and specific patterns of economic policy response, they do underscore the ways in which the stock market potentially reacts. Viewed in isolation, a decrease in economic growth by around 0.2 % per annum as shown in the analysis may not appear particularly remarkable. However, the cumulative effects can certainly assume substantial dimensions over the years, with consequences for the fundamentally justified share price. Applying the so-called Gordon model, which factors cumulative future earnings flows into share valuation, a 0.2 % deceleration in the rate of real earnings growth causes the stocks fair value to drop by roughly 5 %. All told, inflation can impact on both profit margins and real economic growth through various channels. As a result, inflation curtails corporate profits and earnings per share.2)

INFLATION STOKES INFLATION UNCERTAINTY

Were inflation to remain constant over many years, it would not give rise to any particular concern among market players, who would be able to anticipate it. Markets could come to terms with the regular price increases and factor them into their planning in a timely fashion. As we all know, however, inflation is prone to marked fluctuation over time. These fluctuations in inflation are closely related to the level of inflation.
High inflation rates carry high inflation risk

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1 2 3 4 5 6

This link can be traced more precisely with reference to the two adjacent charts. 3) The upper chart depicts the correlation between the level of inflation (more precisely: the mean value of inflation rates) and inflation uncertainty (more precisely: variance in inflation around the mean value) for time intervals of varying length. 4) Applying, for example, the one-year intervals between 1950 and 2003, we find a positive correlation of around 0.2 between the resultant 53 inflation means and inflation variances. However, with a transition to three-year periods the link between the resultant inflation means and variances becomes closer: the correlation coefficient climbs to almost 0.7. The longer the period examined, the closer the correlation between the level of inflation and fluctuations in inflation. A low average inflation rate is accompanied by marginal fluctuations in inflation, whereas strong shifts in inflation are to be found in an environment of high inflation rates. This significant connection between the level of inflation and inflation uncertainty is illuminated from another angle by the next chart. It depicts the relationship, for the entire period from 1950 to the end of 2003, between the current level of inflation and its change in 1, 2, 3, ..., 20 quarters.5) These calculations underpin the close connection between the level of inflation and longer-range inflation uncertainty. Looking, for example, at the following four quarters, the link between the rate of inflation and the subsequent change in inflation is still comparatively tenuous; although positive, with a reading of less than 0.2 the correlation coefficient is not particularly
These results could be refined further by distinguishing between so-called supply shocks (such as productivity changes or oil price increases) and demand shocks (growth in demand fueled by extremely expansive monetary policy or a sudden surge in demand from abroad): supply shocks heighten the negative correlation between inflation and equity prices, while demand shocks lessen it. 3) The following analyses are based on work by L. Ball and St. Ceccetti (Inflation and Uncertainty at Short and Long Horizons. Brooking Papers on Economic Activity 1; 1990 4) The correlation has been calculated for non-overlapping periods. The following empirical results remain valid even if the GDP deflator is used to calculate the inflation rate, instead of the consumer price index. 5) Formally speaking we are dealing with the correlation between the rate of inflation at any point in time t, infl(t), und (infl(t)-infl(t+n))^2.
2)

Increasing correlation between inflation rate an inflation risk over time

0.8 0.6 0.4 0.2 0 1 3 5 7 9 11 13 15 17 19

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convincing. By contrast, looking 8 to 20 quarters ahead, the correlation moves up appreciably to levels of more than 0.7 In other words: if the inflation rate is high at the time of investment, the investor must expect high fluctuations in inflation over the following two to five years. If, on the other hand, inflation is low, the empirical evidence suggests that the level of fluctuation in the inflation rate will also be low over the following years.

THE OUTCOME: INFLATION DEPRESSES EQUITY PERFORMANCE

Medium-term correlation between share performance and inflation average change (y-o-y) over three years

40 30 20 10 0 -10 -20
1974 1979 1984 1989 1994 1999 2004
S&P 500 US inflation rate

12 10 8 6 4 2 0

On balance, therefore, inflation affects share performance in different ways. On the one hand, fundamentals such as earnings per share are hit. On the other, the longerterm inflationary uncertainty also pushes up the risk premium for shares, placing a damper on performance. The adjacent chart illustrates the negative correlation between inflation and share performance since the beginning of the seventies. Equities were not a hedge against inflation during that period. 6)

THE CONSEQUENCES FOR SHARE VALUATION: REAL OR NOMINAL YIELD?

In an ideal world, where inflation has a negative effect neither on real profit growth nor on risk premiums, a 5 % rise in prices (for example) would lead to an equivalent rise in corporate profits, dividend payments and stock prices. In that case, future dividend payments and stock prices would be inflation-proof, and shares would then function like an inflation-indexed bond. To find a fair value in such a case, the yield on a particular share can, as an inverse P/E ratio, be compared with the real yield on a bond.

P/E ratio and real yield

16 12 8 4 0 -4 1974

In the real world, however, rising inflation and its impact on profit margins and sales markets can have a dampening effect on real profit growth, and thus on the average profit growth rate. On top of this, investors demand risk premiums for shares in an inflationary environment. Both of these effects reduce the fair value of the share.7) The higher the inflation rate, the more a real yield-P/E comparison overstates the fair value. Using this valuation approach, the danger of overvaluation therefore increases with the pace of inflation.

1983
Inverse P/E ratio

1992

2001
Markets evidently price this danger into share quotations. Although a close correlation has emerged in the past two decades between the P/E ratio and the real yield, on closer examination it is clearly apparent that variances between the (inverse) P/E ratio and real yields increase in parallel with the rate of inflation.

US real yield (10yr)

Inflation drives wedge between P/E ratio and real yield

16 12 8 4 0 -4 1974

1983
Real earnings-yiled gap

1992

2001
Inflation rate

The notion that equities provide a hedge against inflation was widespread in the older literature on economics. However, justified doubts regarding the thesis were expressed as long ago as 1976 in an article by Z. Bodic (Common Stocks as a Hedge Against Inflation. Journal of Finance 31). In the meantime, the negative impact of inflation on stock performance is widely recognized in the empirical literature. An exception to this is the article by Boudoukh and Richardson: Stock Returns and Inflation: A Long-Horizon Perspective (American Economic Review 83;1993). Looking at the unusually long horizon of the years 1802-1990, the authors conclude that inflation and (rolling) five-year returns move broadly in parallel. Furthermore, international comparative studies show that stock prices can benefit from inflation as soon as the inflation rate rises above around 15 percent. Clearly, there is a flight to material assets in times of hyperinflation. 7) This is the conclusion reached using the Gordon approach, which argues that, if a stock is fairly valued, the inverse P/E ratio will correspond to the sum of the real return and the risk premium minus the average (real) profit growth rate per share.
6)

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Economy & Markets 0708/2004

P/E ratio, real and nominal yield

14 10 6 2 -2 -6 1961 1967 1973 1979 1985 1991 1997 2003

Real earnings-yield gap Nominal earnings-yield gap

P/E ratio, real and nominal yield P/E ratio on basis of earnings estimates for following 12 months

Should this observation lead us, then, to combine the inflation rate and the real yield, and to use the resulting nominal yield as a yardstick for the fair value of a share? Is a P/E-nominal yield comparison the correct tool for valuing shares? At first sight, this idea looks attractive. Working on the hypothesis, for an investment decision of up to one year, that neither the share price nor the dividend payment are correlated with the rate of inflation and that because of high price volatility on the stock market price fluctuations tend to take place randomly, a comparison of share and bond yields simply becomes a comparison of the (inverse) P/E ratio and the nominal return. This arbitrage concept underlies what has become known as the Fed model. From a theoretical point of view this valuation approach is appropriate in the short run. 8) Moreover, in comparison to the real yield approach it clearly proves to be the more stable rule of thumb.

16 12 8 4 0 -4 1979

1985

Real earnings-yield gap Nominal earnings-yield gap

1991

1997

2003

8)

This arbitrage approach is based on a general random walk property (martingale) of shares.

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