commodities and inflation protection

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence -- but not official government numbers -- that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one's purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is "mostly, no". Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.

stocks and inflation (part 2 of 2)

(This is an update from yesterday's discussion on inflation's effect on markets.)

To augment the information presented in yesterday's post, I wanted to add additional perspective with respect to earnings. Stock prices can be reduced to two components: (1) earnings and (2) a multiple against those earnings. Yesterday's post dealt with the latter without much discussion of the former. So, I've added the chart below to address this oversight.

Readers will note that earnings (dark blue) more than kept pace with inflation over the twenty-five year period from 1964 through 1988. Certainly, if it were possible to invest in corporate earnings alone during this period, an investor would have fared quite well. This is the crux of the argument made by those who believe stocks will keep pace with inflation -- that corporations will raise prices and earnings will largely keep pace. Unfortunately, it's the 'multiple' component that hurts investors during inflation - if ending valuations are meaningfully lower than beginning, an investor may not fare well even if earnings grow nicely. And over this period, they certainly did -- real earnings were 50% higher in 1988 than in 1964.

stocks: inflation hedge or vedge?

I want to spend a little time thinking about what markets do when inflation hits. Common knowledge seems to believe that when inflation rears its ugly head stocks will rise in line with inflation. I think we have seen the monetary stimulus from the Fed show up in financial asset prices lately and I want to dispel this fundamental misconception of stocks as a hedge for high inflation with some market history. Note that my comments are not valid for hyperinflation. Almost anything is better than paper money during such time periods. During Brazil's high inflation of the late 1980s and early 1990s the stock market roughly held its own with domestic paper money (but looked flat to a foreign investor). If you’re like me and believe we’ll see elevated, but not catastrophic inflation in the near future it makes good sense to look at what periods of elevated (again, not hyper-) inflation have done to the stock market.

I looked back at a period of time where inflation was low, rose to quite elevated levels, and fell back again to low average levels. In other words, a period containing three "regimes": before inflation reared its ugly head, during high inflation, and back again to more stable, predictable levels. I chose the twenty-five year period from 1964 through year-end 1988 because it nicely exhibits these characteristics.

The chart to the left shows inflation (consumer price index) in red, the S&P 500 total return in green and the real return (total return minus inflation) in purple. Each is indexed to 100 at 1/1/1964. Clearly, stocks (green) did not keep up with inflation over this time period while the real return on the market over was negative. That’s a pretty poor showing over a period when inflation boosted the consumer price level to almost 4 times its starting point. If stocks were a good inflation hedge we’d expect the green line to be persistently higher than the red, and meaningfully higher at 12/31/1988 if real returns were positive. However, this does not seem to have been the case.

Why were stocks such a poor inflation hedge over this period? The answer lies in valuation. Using Shiller’s cyclically-adjusted PE ratio, which I’ve cited often, the S&P 500 traded at 21.6 times earnings in 1964. By year-end 1988, they were just 14.7, a P/E decline of 32%. The chart below shows the inverse relationship between inflation (red) and stock valuations (cyclically-adjusted PE, green). Over this time period, the correlation between the two was negative 0.956, representing an almost perfect inverse correlation. High inflation proved to be an enemy when stock valuations started high.

Why is inflation so hostile for stock valuations? It comes down to interest rates; nominal interest rates must include compensation for inflation plus a real return component. Investors ultimately compare this rate against the "coupon" available on stocks - that is, corporate returns on equity (ROE). Since ROE does not tend to fluctuate much over long periods and is more likely to fall than rise during high inflation, the yield available on stocks can only change if their prices move lower (coupon "yield" relative to book value moves higher). Maturities are also compared – bonds have a definite maturity while a stock’s maturity is infinite. I’ll defer to Warren Buffett for further clarification: “Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent return on equity versus, say, 10 percent return on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

Historical stock returns are likely to have looked much different if starting valuations were much lower than the 22 PE we see in the above illustrations. Because of these elevated levels, inflation had a demonstrably large impact on longer-term returns. While starting valuations always matter for subsequent returns, they seem to matter even more during high inflation.

Could this happen again? Well, today the cyclically-adjusted PE ratio is 23.7, so valuations are even higher than where these charts begin (1964). Even if you believe the Fed has everything under control and we won’t see high inflation anytime soon, it’s worthwhile to consider the aforementioned data when allocating your portfolio. The importance of stable prices is most noticeable when they go missing.