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Higher inflation strengthens the case for equities

Last week’s inflation figures from the Office of National Statistics revealed a surprise increase in the Consumer Prices Index, after several months of falling inflation.

The figure from July, showed that CPI had jumped to 2.6 per cent from 2.4 per cent the previous month, while the Retail Prices Index increased to 3.2 per cent from 2.8 per cent in June.

This increase highlights a significant problem for long-term investors and savers. Many investors are still relatively risk averse but any assets held as cash are under real pressure from inflation.

Figures from Moneyfacts show that at 16 August, the best rate available for an instant access savings account, without an introductory bonus, was paying 2.8 per cent interest, just 20 basis points over the rate of CPI. In total, only four accounts are offering interest rates in excess of the rate of inflation.

As J.P. Morgan Asset Management head of UK marketing Keith Evins points out, for many people, extra investment risk is necessary to beat inflation.

Evins says: “While cash definitely has an important place in people’s lives, too often savers are put off diversifying into equities by the risk of loss. What they don’t focus on is the opportunity cost of clinging to cash – that is, the returns they might miss out on.”

However, the long-term assumption that equities grow at an average of 6 to 7 per cent, adjusted for inflation, recently came under assault from Pimco managing director Bill Gross.

The head of the world’s largest bond fund manager said the 100 year trend, known as the Siegel constant, that shows equities returning 6.6 per cent after inflation will not hold true in the future. He argues that as long-term GDP growth has averaged 3.5 per cent, and if you expect this to continue, it is highly unlikely that equities be able to grow in value by more than 3 per cent in excess of GDP.

When you add in the age profile of many investors, that is approaching retirement and increasingly unwilling to take investment risk, and the that of inclination of ability to afford to invest in the stockmarket, Gross says: “The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well.”

Gross also flags up the strong probability of long-term inflation for developed economies, not least because of the benefits for heavily indebted governments. But, he warns, this is also bad for shareholders.

Gross says: “Woe to the holder of long-term bonds in the process! Similarly for stocks because they fare poorly as well in inflationary periods.

“The problem with all of that of course is that inflation doesn’t create real wealth and it doesn’t fairly distribute its pain and benefits to labor/government/or corporate interests. Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades. Financial repression, QEs of all sorts and sizes, and even negative nominal interest rates now experienced in Switzerland and five other Euroland countries may dominate the timescape. The cult of equity may be dying, but the cult of inflation may only have just begun.”

But with investors needing some way of combating the threat of inflation, are equities really a lost cause?

Fund manager GMO has published a white paper in response to Gross’s comments, Reports on the death of equities have been greatly exaggerated, in which its head of asset allocation Ben Inker says there has never been a strong correlation between GDP growth and equity returns.

Inker says: “The first point to understand about stock returns is their relationship with GDP growth. In short, there isn’t one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns.”

With Japan, Spain and Italy all experiencing much higher GDP growth between 1900 and 2000 than the US, the UK or Australia, however, the all three saw considerably lower stock market returns over the same period.

In addition, Inker points out that it is possible to equities to continue to generate returns considerably in excess of GDP growth because most of the excess returns are due to dividend payments, not capital growth.

He says: “When we look at stock market returns, dividends have a very large impact on the total, providing the bulk of equity investor returns for most of history.”

And as investors are investing for a reason, generally to fund future spending, the returns do not keep stacking up. Instead, investors continue to take profits.

“A return on investment higher than GDP growth leads to no logical impossibility because those returns are not simply hoarded and reinvested in perpetuity. If a slow-growing country invests as if it was fast-growing, it will have a dismal return on equity, as Japan has ably demonstrated for the past couple of decades. But slow-growing countries like South Africa and Australia had very strong stock market returns in the 20th century, having had both the good sense not to lose a major war as well as a decent combination of cheap stock markets and good return on equity. Those returns funded plenty of spending by the holders of those equities, leaving their descendants possibly fairly well off, but not the owners of 140 per cent of local GDP.”

Brewin Dolphin head of portfolio strategy Guy Foster says that Goss’s dismissal of equities is also a bit wide of the mark.

He says he has some sympathy for the idea that the Siegel constant should not be taken as gospel truth.

“Personally I find the relevance of stock returns before the invention of transatlantic communication, or indeed the eponymous sliced bread, to be somewhat tenuous (there was no Italy to haunt early nineteenth century investors for example). So, to me, comparing current financial markets to those a century or two ago is futile.”

But he says there are plenty of reasons to think that equities will continue to offer investors value. First, the move from defined benefit to defined contribution schemes will create greater demand for equities, while the de-risking of DB schemes will simultaneously reduce investment risk for companies with big pension liabilities.

And while he concedes that the austerity measures adopted by many governments will lead to a weaker economic environment, the policy measures used to combat slowing economies, low interest rates and quantitative easing, are beneficial for equities in the long-term.

Foster says: “The equity culture therefore seems far from dead. Indeed it seems likely to thrive, consuming other savings cultures such as cash and bonds, as our economic malaise, combined with the effects of the policy cattle-prod, force investors seeking any kind of meaningful return on their assets to buy equities.”


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