Are Equities A Good Inflation Hedge?

Tyler Durden's picture

While many believe that with the output gap so wide that inflation is not an immediate threat, longer-term, as UBS notes, excessive money printing could indeed generate inflation and that inflation expectations are unusually volatile and could quickly be dislodged. This inflation hedges are a very valid concern. An oft-cited reason for owning stocks is that they have an implicit inflation hedge, however, just as with many market myths, UBS finds that, in fact, equities do not look like a compelling hedge against rising inflation.


Via Stephane Deo of UBS:

Indeed, they provide an appropriate hedge to rising inflation only in a limited number of cases.

  1. The trade has to be entered at a low level of inflation. If the trade is started above 4%, the valuation loss due to declining P/E will dominate and make equities underperform.
  2. If inflation increases only moderately. High-single-digit inflation would make the equity valuation loss dominate other effects. 
  3. If the investor assumes that inflation will not decline. In that case, the trade would also generate sub-inflation returns. So an equity hedge comes with increased portfolio risk in cases of deflation. Here are our arguments.

If inflation surges, it is because companies are selling their goods at a higher price and, as earnings are a fraction of sales, surely earnings would move in tandem with inflation giving protection to investors. If the payout ratio is constant dividends would also mimic inflation even if some price distortions can obviously affect corporate margins. And indeed when we compute the ratio over the past century and a half between the US CPI and EBIT inflation (we remove the volume effects from EBIT), we find a decline by 0.02% per annum. This is low enough to be negligible. EBIT prices do move in tandem with inflation.


Unfortunately, the story is not that simple; if inflation is high and stable, the above argument makes sense. But the situation we are facing is the risk that inflation will jump from low to high levels. That has a very unpleasant consequence: a change in the discount factor and risk premium. On a DCF approach, the discount factor will go up, hence the accrual value of the future flows will not be multiplied by inflation, but by less. Higher inflation also means higher nominal volatility, hence higher risk premium, hence an even higher discount factor. So the P/E will adjust to take the new world into account. All prices have increased with inflation, except the price of the equities you have in your portfolio which has risen by less than inflation. You are not hedged.


Let’s go back to the real world. Our argument is that P/E or earning yields should move in tandem with inflation. We did investigate this issue in the past and actually found a very strong positive correlation between bond yield and equity earnings yield when bond yields are above 5%. But we find an equally strong correlation when yields are below 5%, only this time the relationship is negative. This is clearly visible in the two charts below.


From an economic point of view, this actually makes sense. Yields/inflation at a low level would signal that the economy is approaching a Japanese scenario, or is on the verge of deflation. Further decline in yields are negative for equity. By contrast, yields above 5% are associated with inflation rising to a level that becomes disruptive, with an associated increase in nominal volatility hence risk premium. The chart below shows a similar relationship with inflation: we find that 4% is the threshold, or the sweet spot, where equity prices are maximized.



This weakens the case for equities as an inflation hedge, because it means that, with inflation above 4%, equity valuations will start to play against us.


So let’s run the numbers, we start from the current inflation number, 2.2% in the USA. If inflation goes up, not only would equity return more because the nominal EBIT will follow inflation; but the valuation of equity improves as we approach the 4% magic number. In short, we have a hedge to inflation that returns more than needed. But if inflation increases above 4%, the valuation starts to deteriorate. We find that with inflation around 6.5% the valuation argument starts to bite so much that inflation protection starts to be eaten away and the equity return is less than inflation. The further inflation increases above this mark, the more equity valuation drops and the worse the inflation hedge becomes. We even find that with inflation around 9.5%, despite the increase in nominal EBIT, valuation destroys all the equity return.


Obviously, if inflation drops from where it is now, valuations deteriorate, hence equities underperform inflation as well.


In short, equities provide only a partial hedge – one which works only for small positive inflation shocks.


There is one additional point to keep in mind: the entry point of the trade is very important. Imagine that you wait for inflation to go to 3.5% before you get really worried and put on a long-equity trade with the view of protecting the portfolio against inflation. Because the position starts from a level much closer to the 4.0% sweet spot, the starting valuation position is much better, hence more demanding. It means that the negative valuation argument starts to bite much earlier. Indeed, if we update the above chart with a 3.5% starting point, the result is that protection disappears after just 5.0% inflation.


Conclusion: So, in short, an equity portfolio does not look like a compelling hedge. It works only for reasonably small shocks and if the trade has been entered early enough. It also increases the risk to the portfolio in case of deflation. The analysis, however, does not go into the breakdown by sector. A better sector approach, one which would overweight sectors with a low duration, would probably provide more supportive results. This is one interesting research avenue for the future. For now, the solution we propose is to create an inflation linked credit market.


Source: UBS

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kaiserhoff's picture

Sweet Jesus, this broad thinks she can nuance/arbitrage inflation?  Barry's arrogance must be contagious.

Just a few horror stories:

Tax rates are not indexed, meaning with any real inflation, effective rates go ballistic.

Manufacturers get one profit, in current dollars, but must pay for defects/recalls/etc. forever in inflated bucks.  That can't be insured or funded.  That killed general aviation in the seventies and began the great exodus of US jobs.

Any planning beyond a couple of months becomes a crap shoot at best.  Think farming, ranching, heavy manufacturing, any expansion..., fill in the blanks.

That dog won't hunt.  Too many volk already going feral, native, gypsy.  Winter is for those who can't read a compass.  Print more money Ben.  Ask if anyone wants your toilet paper.

TruthInSunshine's picture

I think not. In fact, just the opposite. Inflation kills both aggregate demand, and ultimately, corporate margins.

As to another aspect of what any sensible person knows are batshit crazy, detached from any true fundamentals, equity, bond or credit markets we find ourselves witnessing again, The Economist (whose opinions I respect even if I don't always or even often agree with, but which has made some pretty damn good calls; see here-- published in 2005-- for such an example: House prices: After the fall | The Economist)  has a great article analyzing the views of several economists who've come out and flatly recognized what many of us have been stating for a while now, to wit, The Bernank & Gang have now re-inflated massive bubbles via wholly radical fractional reserve fiat interventionism on an epic, insane level, and in the process, BROKEN ALL MARKETS (I've used this phrase for at least a year now).




kaiserhoff's picture

I think I see your point.  I was talking seventies experience.  You're looking at now.

If wages don't rise, demand dies and the whole thing collapses into depression or worse (law of the jungle).

In either case, not sure any of this will last long enough to worry about financial planning, whatever that used to be.

TruthInSunshine's picture

Bingo. You addressed the point I (honestly) was going to, yet that I left off for fear of being too verbose (I check myself once in a while).

There is no leverage for wage increases, by and large. Unless you're literally an extremely specialized, extremely productive, among a select few who can prove your monetary worth down to the penny, as a wage slave you simply have no pay raise leverage in this brave new world of globalized, out-sourced, in-sourced, part time, flex time, work-from-home, work-remotely-from-overseas, labor.

Labor is the cheapest commodity of all today, with very few exceptions.

Unless The Bernank or the illustrious Paul "When Mars Attacks" Krugman want to state their case as to the hows and whys, with great & compelling specificity, of how wages will keep up with, let alone outpace, the true rate of inflation, they're liars & mountebanks of the worst kind.

TraderTimm's picture

That's why I like bitcoin. Up 240% since Jan 2012. Screw the rigged equity market.

Can you imagine trying to get yield as a retail customer on a 0.9% checking account? A bank's paltry CD?


bankonthebust's picture

Be honest now... We all know the only reason your buying bitcoins is so that you can use them to buy drugs online.


Not saying theres anything wrong with that.

CPL's picture

There you go.  A business community starts with barter and haggling, lots of examples you can buy and sell things other than drugs.  Like tonnage of wheat.  Tankers of oil.  Favorable rates on forex exchanges using Bitcoins are your middle man.

TraderTimm's picture

Actually it has a lot to do with monetary freedom, and the lack of economists pulling levers and hitting 'Ctrl-P' every chance they get.

Underground markets are always first in adoption of new technology. No surprise there. Of course, the US Dollar is old chums with all of the above, except it has the decided disadvantage of not being decentralized.

I deserve the gain because I'm taking the risk. You know, like how the market used to operate before the hucksters and algorithms ruined it. There's still time to research and invest, but I suggest you do so before the next big player steps in. It might make things a bit more expensive for you.

That, and the fact that good old Bernanke isn't going to stop printing his way to financial doom.

SpykerSpeed's picture

Bitcoin is a fantastic tool, and I wish more people on ZeroHedge took the time to actually study it.  Everyone who understands computer science and Austrian economics sees what an amazing innovation Bitcoin is.  During a global fiat collapse, Bitcoin will be a fantastic way of facilitating trade, because it is far more easily divisible and verifiable than gold or silver.  That's not to say that gold and silver aren't good stores of value.  But for day-to-day purcahses, nothing can beat Bitcoin.

SanOvaBeach's picture

I agree!  Bitcoin is a fantastic tool.  The reason not many people on ZeroHedge take the time to study it is because many ZH'ers are pseudo-intellectuals.  And many are survivalists living in caves and collecting canned goods.  Many are stupid rednecks with pick-up trucks w/ shotguns hanging from the back window.  Remember the end of the movie Easy Rider?  Many on this blog are really quick to critisize but offer no solutions or at least try to.  I consider that loser behavior.  Have a nice day!

SanOvaBeach's picture

By the way, for those very closed-minded ZH'ers out there (u know who you are) you can buy gold/silver bullion or coins w/ Bitcoin.  Hey, you computer scientists out there.  Put in laymen terms, what is a block?

Banksters's picture

I'm still wondering why dr. (subprime is contained) bernank isn't in FUCKING JAIL.    


“We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”

Dr. bernank  2005



“It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions.”


“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” 



Honey Badger's picture

Negative convexity Bitchez

dscott8186's picture

Except that the experience of Zimbabwe says otherwise.  Equities held their value relative to inflation.  

Charts and graphs are all nice dog and pony shows based on the false premise - all things are equal.  It's called the extrapolation fallacy.  

What's not equal is that some businesses are going to fail thus giving breathing room to the remaining to survive.  In the end, the product will still sell. 

Finally, in a high inflation environment, no one makes investments with borrowed money since no one is going to loan it.  In fact, the imperative is to wait for the existing issue bond value to drop like a stone and then buy back your debt at pennies on the dollar with cheap money.  

devo's picture

You're comparing the US to Zimbabwe?

Anyway, stocks are better than dollars, but not better than gold, oil, land, etc.

CPL's picture

If your stocks are in dollars, you've still got the same problem as holding dollars if priced in dollars.


devo's picture

The dividends would be worthless, yes. The principle, so long as you don't sell, should  be somewhat protected (more than dollars). Inflation doesn't reduce the # of shares just like it doesn't reduce the # of ounces of PMs. Corporations won't be able to pass on costs with wages decreasing, etc. People will just stop spending. This is the problem with stocks.

All this being said, I think silver is the best investment right now. When all the selling from the spike to gold $1900 exhausts itself I think we'll see a huge move to silver $80 within a few years.

Bindar Dundat's picture

All of the money is building up within the banking systems. I have a few ideas about what is going to happen next.

 We will see deflation first for the next few years so all of our assets can be purchsed ( stolen)  cheaply. I would think housing, land and gold will drop another 30-40% before they increase the hounds and the velocity of that cash starts to drive inflation.  The prices will go up so that we will never get a chance to own anything again.  There is no science to support this thesis.  It is just what I would do if I was dealt this hand and had no morals.

So before you see $ 80 silver you will see it at $ 16-20.  Sorry , but you will lose your house too and your savings.   


EscapingProgress's picture

If all of these central banking shenanigans are part of a sinister plot then you are absolutely right about that end game prediction. But, if it really is just a bunch of ivory tower idiots screwing everything up through their incompetence and hubris then who knows what's going to happen next. Weigh the evidence and decide for yourself. It gets harder and harder everyday for me to believe that this is all just a series of unintended consequences stemming from bad economic theory.

Freddie's picture

Why shouldn't he compare the USA to Zimbabwe - spudboy?  We ain't in Akron anymore dancing the poot Booji Boy.  

When our dear mullah was "elected" - I pretty much thought he was the next (islamic) Mugabe but hoped I would be wrong.  I was not wrong.

vato poco's picture

"Equities hold their value relative to inflation"?? Really? I was just a punkass teenager at the time, but I seem to recall the stock market was essentially flat from 1974-1982 - while inflation was running wild. Now, *gold & silver*....sure. To the moon!! But equities? Not so much. In fact, not at all. Am I remembering wrong?

SanOvaBeach's picture

Did just that in the 70's...............

DavosSherman's picture

"Are Equities A Good Inflation Hedge?"

If you're a fucking moron and until the bottom fucking falls out.

Gold n Silver bitchez!

JR's picture

Stock reports suffer from substitution bias the same as retail sales reports that only measure sales at stores that have been open for 12 months or more; those that have gone out of business are simply tossed aside.

Nathan Martin of Economic Edge wrote a while back: “This is the same exact error that causes people to think that STOCKS rise over the long haul when in fact stocks on a whole do not rise in the long run – they live through a life cycle and eventually die.  It is only the indices that rise, and that rise over the long haul is ONLY due to substitution bias…”

In a similar vein, Martin wrote in August 2009:“I want to point out the MYTH that stocks have returned on average 7 to 8% annual returns over the ‘long haul.’  BS!  Here’s the truth, and it is heresy to all the people who make their living from Wall Street—ALMOST ALL STOCKS EVENTUALLY GO TO ZERO in the long haul.  The only think that does go up in the long haul are the manipulated stock indices which replace failed companies with new ones.  For example, the DOW Industrials has 30 companies—the only one still in existence is GE, a company that has made itself functionally insolvent due to its involvement with finance and derivatives.  That’s called substitution bias, and that’s the truth about stocks—in the long haul.”

dscott8186's picture

There in lies the crux of the matter, the index fund.  What you say is all true except that index goes on, as a tactical manner buying only the index is your hedge against inflation, not individual stocks.  

However, in a hyper inflationary episode the writer of the article made an implied serious false assumption. That the companies engaging in commerce would continue to use the hyper inflating currency.  By the experience of Zimbabwe, Argentina, Mexico and Chile, people cease using the hyper inflating currency as a practical matter long before the government gives up on it.  

In those cases people making purchases used the Dollar to bypass the difficulty of a value changing currency note.  In doing so, the equity value of the company while valued in the hyper inflating currency goes up according to the EXCHANGE RATE independent of sales (TTM) since it is the BOOK VALUE of the company that would determine it's actual worth.  The exchange rate will protect the investor whose shares are valued in the hyper inflating currency much like hard assets.

How we in the US will deal with this will be problematic since it will be the Dollar that will be hyper inflating leaving us with very few choices like the Yen or the EUR.  

SanOvaBeach's picture

Canned goods and a shotgun, right?  See what I mean, kids!

devo's picture

No, no they are not.

hairball48's picture

What good are equities if they are denominated in a currency(like the US$) that is going bust?

rsnoble's picture

Equities "were" a good hedge had you bought stocks when Obama told you to. You're just fucked now.

Insideher Trading's picture

Strangely enough I have come to the conclusion that aside from excessive money printing, taxes are a chief progenitor of inflation.

I travel a lot and one the things I've noticed is that where local taxes are higher...the prices for everything are higher.

Take for example cigarettes. I was in Connecticut recently and a pack of ciggies were $10. I was also recently in VA where a pack of ciggies were $4.50. The vendor in CT was barely stocked with ciggs, the wall behind him was mostly empty but for a few packs. The vendor in VA was flush with cigs and making nice profit selling them. So I start thinking about the cost of living, inflation, and taxes...

The inflation and cost of living is the highest in states that levy the highest amount of taxes against their citizens. I think to myself...what's the one thing all of us use? Energy. What are the taxes like on energy across the U.S? Here are the results:

Now compare the median wage and the cost of living in the states that levy the highest taxes on their citizens. You will find (as I did) that the citizens in states with lower taxes and lower median income could afford MORE than citizens in states with HIGHER median income and higher taxes. The UE rate is also much lower in states with lower taxes than states with higher taxes.

And what happens when you raise taxes on business? You think that business pays the tax? They raise the price of their product or service and who suffers as a result? The poor and the consumer.

CPL's picture

Because tax increases are in percents.  And it's in every transaction.  Let's do 10% basic flat tax.

Farmer grows the apple:  Sells a bushel of apples (about 50 nice apples) for 5 bucks.

Government collects $0.50 per bushel.

Distributor bags the bushels to imperial weights of five pounds each, or ten apples. for a per unit cost of 2 bucks.

Government collects $1.00 for the sale of the transaction.

Apples make it to a grocery store and a sold for $4.00 a bag

Government collects $4.00 for the sale of the apples.


Government made 5.50 for doing nothing but pushing a tax on a transaction.  I only used a fictional apple.  Think about something like gasoline where an average 70% of it's total cost at the pump is tax (dead serious).  For every 3.315, 2.32 of it goes to a government agency somewhere.


So 8.74 million barrels per day are consumed just by the US alone...1 barrel is 31.5 gallons.  Or a total of 275,310,000.


Or $638,719,200 per day in taxes is levied on a single good everyone uses.  Oil just in taxation makes government $233,132,508,000.


One.  Single.  Item.  Add everythinge else and you start to wonder...where does all that money go?

Insideher Trading's picture

But that's the phenomena. Poor people want higher taxes on themselves but complain when prices go up. 

I find it to be a vulgar demonstration of power on their part: voting for higher prices and then complaining about it.

kaiserhoff's picture

I see what you see.  The question increasingly becomes not just why you would live in New York or California, but how?

When mass migrations are forced..., there goes the neighborhood.  All the neighborhoods.

ZFiNX's picture

Chinese equities are the best hedge in my opinion. You gain from the exchange rate (after the dollar becomes paper mache' leftovers) and the robust economy (A recession is 5% growth). AND it's stock market is currently undervalued if you believe the chinese consumer will lead the recovery, which I do. That's a population with 1.5 billion people, and no one even has a credit card yet. Imagine the effects of America over the last century times 5, maybe to the power of 5. ME getting divvied up as we speak among the major powers, IMO. Obama might be ready to cause the fiscal cliff crisis which justifies a seizing of financial powers (i.e. Debt ceiling authority).

Longing for the old America's picture

If equities don't keep up with inflation... bonds and cash will be even worse.

Stocks are still the best house in a shitty neighborhood once called America.

Cabreado's picture

Where to best stash the cash when the Undercarriage is (knowingly) broken...

a tired cliche, but we do Roman well, don't we...

shuckster's picture

Some equities are terrific inflation hedges. But you must know where inflation is felt. Like in WMT. Their stock is through the roof - why? because of food stamps!! that is where all the moochers go to spend your money on the 1st and the 15th. what is it going to take? when will you decide that you've had enough. do you need to eat your last cold poptart before you realize "this is BULLSHIT". What is it going to take. This Christmas, when you go, with your family, huddled together, perhaps warm, perhaps cold, around the Christmas tree, which you may or may not have been able to afford decorations for, what are you going to think to yourself? Are you going to be thankful? Or are you going to say "enough". What does it take? What is it going to take to break you? To break your last nerve? What will it take?

Freddie's picture

The idiots will just keep watching TV and Hollywood's shit like little slaves.  They will love Jamie Foxx/Obam new film about how he loves killing white folk.

Until people turn off TV enmasse and tell them to shove their ****ing Matrix then nothing will change.  This destruction of America is by design and TV and Hollywood are 100% behind the elites doing it.

ekm's picture

Big guys (Primary Dealers) owning almost all S&P are like a casino that has a lot of chips but no customers.
Eventually the casino will have to lower the entertainment prices so those prices become affordable for the customer.
Stocks are neither crude oil, nor grains nor copper, nor silver, nor food. They don't even exist on paper, they're just electrons in computer.

The chips in the current casino are too expensive. Time to offer 2 for 1.

chinaboy's picture

Equity is very much an American myth.

kaiserhoff's picture

Confucius say:  Smoking crack make you talk stupid.

akak's picture

Anonconfusedcious say: Smoking crack is an 'american' middle class thing, the crustiest bit of the mattering thing in US "american' citizenism eternal nature.

SanOvaBeach's picture

Did your mommie fold your underwear right, this time?

CPL's picture

I think you are looking for the word Equality.


Equity is any of value that can be used or traded.

chinaboy's picture

Please tell us who are you equal with? Anyone in 1%?

AldoHux_IV's picture

Talking about whether inflation has hit especially looking at market indicators and econ points (which like the market, are all fixed to say something else) is like saying a fat person can't eat too much chocolate because they may get fat or perhaps Bernanke and central bankers et al could be making mistakes if they continue printing after they've printed trillions already.

Inflation and deflation exist already-- they are used as excuses/boogyemen to engage in policy that furthers the riches of the rich (or fund super governments in their attempt in taking over the world) and systematically transferring wealth and resources from the unknowing masses.

But what do I know-- I'm just a denizen in a world of apathy, greed, and psychopathy.

Steve in Greensboro's picture

Inflation-linked credit market, eh?  If the debtor calculates the inflation rate, I'm not buying, particularly a debtor whose chief executive is a Kenyan kleptocrat.  How about debt denominated in a stable currency?  Like gold.