Alasdair Macleod – 25 March 2011
This is the third article in a series describing the disadvantages of inflationary policies. The first concerning the effect on savings is here.
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credit cycle in this simple theoretical example should perhaps be completed by the excesses of money and credit being withdrawn: in other words the mistake of an expansionary monetary policy is realised and corrected.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.