Zero interest rates, an endless array of stimulative measures taken by central banks, and yet no sign of inflation. Quite the contrary. US inflation stands at only 1.2% and has fallen below the 1% threshold in Europe. It’s deflation we have to worry about. And deflation is bad for almost everything. We postpone our purchases, leading to lower company sales, which lead to lower investment, increasing unemployment, and so on. Moreover deflation raises the (nominal) value of debt. All this must be disastrous for equities as well, right?
High to low
Let’s find out. Using long-term return data (starting in 1900) from Dimson, Marsh & Staunton[i] (2013) and inflation data from Measuring Worth[ii] I will try to shed some light on the relationship between US equity returns and inflation. The idea is pretty straightforward. Combine the return and inflation data for each year and divide these years into separate buckets. One bucket holds one-third of the years with the highest inflation, another bucket contains one-third of the years with average inflation and a third bucket holds one-third of the years with the lowest inflation numbers.
In addition, to get a grip on what happens at the far ends of the data sample I construct two more buckets; one with years in which inflation was exceptionally high (arbitrary chosen to be 8% or more) and one bucket with only ‘deflation-years’. Analyzing the returns of these five buckets should give a pretty decent clue on the relationship between inflation and stock markets. To be clear, I take real returns, hence after inflation. A 15% return sounds impressive, but is in fact disappointing when it is accompanied by 10% inflation.
The results are shown in the table below. The blue bars represent the average real return on US stocks in the coincident year over which the inflation was measured (so inflation and return for year 1900 and so on). The bars reveal a clear relationship. The lower the inflation rate, the better for stocks. If we move from high inflation buckets to low inflation buckets, the average realized return goes up. Moreover, in years in which inflation is negative (deflation) the real returns averaged an impressive 16.7%. Based on these numbers deflation is actually pretty sweet for your investment. High inflation, on other hand, results in miserable returns. In years with inflation above 8%, you lose a hefty 8%. The hypothesis that equities provide a good protection against inflation is strongly rejected, at least based on these yearly averages.
Hold on. Don’t clean out your savings account right away. There is more. Equity markets are forward-looking by nature and we have to take that into account. That’s where the black bars come in. They show the average real return in the years preceding the year over which inflation is measured. Hence, the inflation in year 1901 combined with the return of year 1900 (lagged 1-year), etc.
Let’s look at extreme inflation-years first. The results are comparable to those represented by the blue bars. The lagged-one-year average return is again negative. Not as worse as the coincident year average, but -0.1% is disappointing. For deflation there is a big difference compared to the blue bars. In the year preceding deflation the average return is barely positive (0.4%). That is hardly worth the trouble. Hence, extreme inflation seems related to negative returns in any case, while deflation is very sweet for equity returns but only in the coincident year. The year before it’s better to stay away.
Although impressive, the results are not completely satisfying. A look at my Excel sheet reveals that all years in which inflation was negative occurred before 1955. Also the way inflation is calculated could have influenced the results. In the early days no official monthly CPI data were published. Also, some data was calculated in retrospect and then used to calculate annual inflation numbers. This surely must be different from a situation in which investors are confronted with negative inflation numbers month after month.
Therefore, I do the same exercise again, but now starting in 1955 and with use of monthly inflation data (Bureau of Labor Statistics[iii]). Averaging the twelve monthly inflation data numbers leads to a more realistic calculation of annual inflation. This way I find two other deflation years (1955 and 2009). Of course this is not enough to draw any conclusion. Instead, for the period after 1954 I create a bucket that contains the years with very low inflation (lower than 1.5% and including the two deflation years), instead of a bucket with negative inflation-years. The results are shown in the graph below.
‘Vigilant’ on inflation
The blue bars, again representing the average returns for coincident years, reveal the same pattern as in the first graph. The lower inflation, the better your return. Is inflation expected to come in below 1.5%, it seems wise to convert your savings into equities. In low inflation years, real returns have averaged a solid 13.6%. But, more importantly, the average real return in the year preceding the year of low inflation has also been very decent. The lagged 1-year return has averaged 7.1%, comfortably above the average real returns for all years. In the last 60 years, low inflation has been beneficiary for stock markets.
Not so for high inflation. Extreme inflationary years (now set at 6% or more) have been harsh for your equity investment. In high inflation years you would have made only 1.9%, and in the year before that you would have lost already some 7% on your investment. From whatever way you look at it, high inflation is a very good reason to stay away from equity markets.
Worries about deflation have been greatly exaggerated. You have to be vigilant on high inflation, not necessarily on low inflation. It’s no coincidence that ‘inflation vigilance’ is often mentioned by central bankers. This conclusion should come with some considerations however. This research is based on US data. Deflationary years are usually incidents. The exception is the period between 1928 and 1932 when deflation was more structural. And we all know what happened to stocks back then. And don’t forget Japan of course, the most explicit example of structural deflation. But assuming that deflation will not become a structural phenomenon in the US, the current low inflation environment is probably all an investor can ask for.
[i] Dimson, E, PR Marsh, and M Staunton (2013) Credit Suisse Global Investment Returns Sourcebook 2013.