Inflation, Interest Rates and Stock Prices
One of the most significant changes to the economic landscape over the last year has been the return of inflation. The US inflation rate has risen to 7.9%, the highest reading in 40 years. US inflation has averaged roughly 2% for the last decade and 3% in the 20 years prior, peaking at 5% in 2008. It remains to be seen whether this spike in inflation is in fact ‘transitory’ or not. Many policymakers seem to be abandoning that view now.
Quantitative easing and sustained easy monetary policy have contributed to the potential for higher inflation for some time. But COVID-related supply chain issues and the Russian invasion of Ukraine are the two most immediate causes. The former has resulted in shortages of various goods and higher shipping costs. The latter has led to a spike in global commodity prices, including energy.
Inflation has a direct impact on what we pay for things. It also has a big impact on interest rates. Most central banks aim to curb inflation by raising interest rates. The theory is that when the economy runs too hot, interest rates can be raised in order to cool things down again, and vice versa. The problem is that interest rates are a bit of a blunt tool when it comes to controlling international supply-driven inflation – such as we are now seeing. Higher interest rates in America have little direct impact on the war in Ukraine or shipping from China. They may dampen domestic demand though.
Nevertheless, it seems likely that central banks around the world will respond with higher interest rates. This in turn will have other implications. Our primary concern is how higher inflation and higher interest rates are likely to impact stocks and other assets.
First, higher inflation means higher costs for companies.
However, since the global stock market represents the bulk of the global economy, it stands to reason that one company’s higher cost is another company’s higher revenue. In aggregate, the stock market tends to pass through the effects of inflation. There may be winners and losers depending on the nature of inflation. Good quality businesses are better able to pass through inflation effects.
Second, higher interest rates mean higher debt financing costs.
Companies which have a lot of debt are likely to come under pressure as interest costs mount. The impact of higher interest rates is not so easy to pass through as inflation. In a rising rate environment, overindebted companies will come under pressure.
The low interest rate environment that has prevailed since the ’08 financial crisis has spurred a wave of debt-funded stock buybacks. Companies have taken advantage of the low interest rates to raise debt at almost no cost. They’ve used the proceeds to indiscriminately buy their own shares on the stock market. This has the dual impact of increasing the leverage of these businesses, while simultaneously creating (artificial) demand for their shares. This pushes their share prices higher. It will be interesting to see the effect of this trade unwinding should interest rates start to bite. Not only will earnings come under pressure, but a major source of buying demand will disappear. Should they need to raise equity in order to pay down debt, the effect will be inverted, albeit in a less orderly fashion.
Finally, higher interest rates mean higher discount rates for assets.
When pricing an asset, expected future cash flows are discounted at a rate (the discount rate) to derive a value for that asset. The higher the discount rate, the lower the value of the asset. Central bank interest rates provide a reference point for all other discount rates. When interest rise, so do the discount rates for other assets, implying lower valuations.
The simplest way to demonstrate this is with a government bond. A bond has fixed cash flows on a predetermined schedule with a defined maturity date. This means that the only variable affecting the price of a bond is the discount rate. Higher interest rates => lower bond prices, and vice versa. For any given yield, you can calculate the bond price. As such, bond prices are usually quoted as a yield (which is the discount rate).
Stocks are a little more complicated. Their future cash flows are highly variable and they have no defined maturity date. This means that the discount rate is just one factor. At one time it may be a dominant factor, and at other times be overshadowed by other factors. All else equal, higher interest rates should lead to lower valuations for stocks, which generally means a lower PE ratio.
Interestingly, small changes in discount rates have the biggest impact on valuations when discount rates are very low (i.e. valuations are very high). This makes highly valued assets more sensitive to changes in discount rates than cheaper assets. (This effect is referred to as ‘convexity’ in fixed income management.)
History shows the relationship between inflation and asset valuations.
Since interest rates tend to follow inflation rates, we’d expect to see an inverse relationship between PE ratios and inflation rates over long periods of time. The last 70 years of stock market history demonstrate a weak inverse relationship between the S&P 500’s PE ratio and US inflation. This weak relationship became a lot stronger during the ‘70s and early ‘80s when high inflation was a major factor.
Source: Bellwood Capital, Bloomberg.
Inflation also impacts other assets.
As we already alluded to, bonds are highly susceptible to inflation. This is because they have no mechanism for adjusting the predetermined cash flows to reflect increased inflation. Should we enter a sustained period of high inflation, bond returns are likely to be poor as interest rates rise and bond prices fall.
Property is somewhat similar to the stock market, but since debt-funding is more prevalent, interest rates tend to have a greater impact.
Inflation obviously erodes the value of cash, although higher interest rates tend to compensate for this. (Unless your cash is under your mattress.)
Gold is considered to be an inflation hedge, but with a lot of volatlity (much like other commodities). Over long-periods of time however, gold fails to match the returns offered by productive assets.
There are several implications for equity investors.
Although high inflation is not a good thing for stocks, stocks remain the best long-term inflation hedge. This is because of their ability to pass through inflation over time. The best ways to mitigate the impact of high inflation on your investment holdings are to:
- Maintain a reasonably diversified portfolio of high quality businesses, which can pass through the cost pressures of high inflation;
- Avoid over-indebted companies, which may become distressed as a result of higher interest rates;
- Avoid over-valued stocks where small changes in discount rates will have the greatest impact on valuations.
These three points really sum up our investment process: Acquire and maintain a diversified portfolio of profitable businesses with strong balance sheets at attractive prices.
Remember, inflation is notoriously difficult to predict. We don’t know if we’re headed for a repeat of the ‘70s/’80s, but we can and should always follow a robust investment philosophy and process.