Inflation and
equities
This is the third article in a
series describing the disadvantages of inflationary
policies.
There is a general belief that
equities offer the best protection from increasing
inflation. This over-simplifies the relationship between
share prices and inflation and is only true in certain
circumstances. Gold and silver mining enterprises
however are the true beneficiaries of inflation, but for
investors in bog-standard equities there will be
substantial losses before the final inflation protection
kicks in.
The perception of the benefits of
inflation to share prices often arises from a comparison
to bonds. But on a total return basis, assuming
reinvestment of income, the returns are actually not
much different. The annual return on the ten-year US
Treasury bond over the last forty years was 7.18%. A
lump sum invested in this instrument in 1971 with income
re-invested would be worth nearly fifteen times as much
today, while an investment in the S&P would have grown
only thirteen times, to which one must admittedly add
re-invested dividends.
A greater influence by far is
changes in interest rates. Over the credit cycle,
interest rates are initially depressed by the central
bank to encourage business investment and economic
growth. It is at this point that equities are usually in
well-established bull markets. The pundits will tell you
that equities are discounting improving profits; while
there is some truth in this the realty is that equity
prices are benefiting mostly from the expansion of money
and credit and low interest rates. But the longer that
interest rates are held artificially low, the greater
the expansion of money and credit and the greater the
inflationary pressures that result. Eventually interest
rates have to be raised, to the detriment of both bond
and equity prices.
The credit cycle in this simple
theoretical example should perhaps be completed by the
excesses of money and credit being withdrawn: in other
words the mistake of an expansionary monetary policy is
realised and corrected. In reality, there is a ratchet
effect, because the credit created in the previous cycle
is allowed to stand, and the general price level is not
permitted to fall. Consequently, the cumulative effects
of these credit cycles are reflected in the long-term
trend for inflation. Share prices reflect this trend
through progressively rising cyclical highs and lows,
supporting the contention that equities offer a hedge
against inflation, while conveniently overlooking the
bear markets at the end of each credit cycle.
The situation today is radically
different in an important respect. Interest rates are at
record lows and have fuelled share price rises,
conforming to the first phase of our credit cycle model.
But instead of inflation arising from excess demand, we
have stagflation, the result of excess money in
circulation. Consequently, the prospect is for
increasing interest rates without the usual economic
recovery.
This statement needs further
amplification: the tentative signs of recovery are
misleading in the US, the UK and much of Europe. The
unprecedented quantities of raw money injected into
these economies have been about as effective as trying
to kick life into a dead body. Meanwhile, the emerging
market economies, which have fuelled export demand for
the West, are over-heating; credit is tightening and
these countries are in the later stages of a
conventional credit cycle. The potential for emerging
markets to create a tide of rising employment in the
mature economies is not there, because this tide has
turned and is now on the ebb.
So corporations in the Western
economies now face a future of rising interest rates and
deteriorating earnings. Not only will this make their
share prices vulnerable to rising interest rates, but it
will radically reduce hoped-for earnings. Therefore,
stagflation has the potential to undermine equity
markets with a bear market of greater than normal
magnitude, destroying any link that protects investors
in equities from inflation. There is a good historical
precedent: the 1972-74 bear market in London reflected
the last severe bout of stagflation, when similar
economic dynamics were in play, and when the All Share
Index fell over 70%.
To relate inflation prospects to
equity prices in all their totalities we must broaden
our debate. In the current economic context, excessively
high levels of monetary inflation from the US are
beginning to be reflected in growing price
inflation in nearly all fiat currencies. Keynesian
economists and other wishful thinkers in the West
continue to attribute rising price inflation to external
factors, dismissing the monetary link. They say the
demand for food and raw materials in emerging economies
is driving up the prices of essentials, and political
disruption in the Middle East is blamed for rising
energy prices. Those in charge dare not admit the
obvious link between excessive growth in raw money and
inflation. Some, like the Governor of the Bank of
England, believe there is insufficient demand in the
economy for prices to continue to rise at current rates.
Others claim that higher energy prices will reduce
demand from cash-strapped households for other goods,
concluding that these higher energy costs are actually
deflationary for other prices, and implying that the
wrong thing to do is to raise interest rates. These are
simply arguments by the authorities and their economic
advisors who are in denial, and they are consistent with
the uninformed level of debate usual in the early stages
of stagflation.
Even though it is slowly becoming
clear to governments around the world that the rise in
the general level of prices is actually a real problem,
policy responses will inevitably be too little, too
late. This is partly due to confusion among government
economists and central bankers, but also fears of the
deflationary alternative. Furthermore all central banks
tie their currencies to the dollar in the belief this is
necessary to protect trade balances, so where the Fed’s
monetary policy goes, the others have to follow. For
this reason the inflationary effects of the Fed’s
unprecedented levels of money creation are being
transmitted into all fiat currencies.
This is the principal danger to
international stability currently posed by the world’s
reserve currency, and government finances in the US
today are so bad that it has no political option but to
continue with monetary inflation in accelerating
quantities. Furthermore, the Keynesian mindset justifies
this flood of money as the only appropriate response to
a stalling economy. These circumstances lead us to
conclude that the current emerging period of stagflation
can only be followed by hyperinflation, not just for the
US dollar, but for all paper currencies. And when
inflation rises to, say, thirty per cent, interest rates
will be at least in the upper teens or twenties.
It is this background that
investors have to consider. Those seeking protection in
equities from this deteriorating outlook will have to
allow for more interest rate rises, escalating raw
material costs for companies and collapsing consumption.
Essentially, the companies that survive a hyperinflation
will do so by winding down their operations. There will
be little or no escape for investors in companies with
foreign earnings, because today’s inflationary problem
is global, thanks to the Fed’s money-printing. The
eventual rise in equity prices at a time of
hyperinflation will therefore reflect the flight out of
paper money more than anything else, and in this respect
will behave like any other physical asset in a
currency’s dying moments. It is Ludwig von Mises’s
crack-up boom, and there is no point in investing today
in any assets based on this eventuality.
The only sector that truly benefits
from the death of paper currencies is precious metals.
The miners will enjoy rising prices for their output,
and dramatically falling costs of production, measured
in gold or silver. Net income, measured in paper money,
expands exponentially, even without any increase in
production. The costs of raw materials and equipment
will rise in paper currency terms, but will be falling
heavily priced in gold and silver, reflecting the
general collapse in economic demand. The cost of labour
will also fall in real terms, and the cost of capital
will become immaterial, as legacy debt is inflated away
and operations are funded entirely out of escalating
profits.
So investors who think that
investment in equities offers the benefits of inflation
protection in this uncertain economic environment will
be in for a rude shock, unless they restrict their
interest to gold and silver mines.
25 March 2011
