Many investors, especially those who have never experienced inflation in their careers, are pinning their hopes on equities to ride out any storm. Such hope, however, may be misplaced.
Investors derive their faith in stocks from two main observations. Firstly, that equities are ‘real’ assets – tangible things that have intrinsic value. And secondly, that many companies can pass on price rises to their customers. This is theoretically sound, but history tells a different tale.
In fact, periods of high inflation have been disastrous for stock markets. As inflation rose between 1966 and 1974 the US Cyclically-Adjusted Price/Earnings ratio (CAPE), developed by Nobel laureate Robert Shiller, fell from 24x to just 8x – the market ‘de-rated’. De-rating occurs when (even if interest rates are held to the floor) rising inflation causes the discount rate on future equity earnings to rise with it. The result is that the present value of future cashflows is much lower.
This would be calamitous for highly rated growth stocks and currently profitless businesses. Given the current starting point of record high valuations for equities and the overwhelming concentration of markets in growth and high PE stocks, it will take remarkably agile stock picking to avoid severe losses in equities if inflation rises.