Value stretches further in short term

Stocks struggle if inflation exceeds 4% or falls below 1%, but if it is well-behaved the stockmarket tends to thrive and rises 7% a year. But the shorter the horizon, the more elastic the returns.

Inflation is back, but does it matter? The theory goes like this: stocks are real assets, real assets go up with inflation, so inflation does not matter. The long-run data backs this up.

Since 1900, stocks in the FTSE All-Share index have delivered an annualised total return of 9.2%, inflation has eroded values by 2.8%, so real returns have been 6.4%. Delving deeper into the sources of return backs this up. Since 1900, the value of stocks has gone up by 4.6% a year and dividends have grown by 3.9% a year; both have grown faster than inflation.

But that is the long-run evidence. Not many of us were around in 1900 to save, sit back and be sanguine. None of us can wait 107 years for the real result. Only index-linked gilts have an inelastic tether to inflation, relentlessly, predictably rising in step. For all other real assets, the tether is elastic so it is possible to be disappointed and to feel the real is an illusion.

The shorter an investor’s horizon, the more elastic the tether. History backs this up. Strip away dividends, focus on the value of stocks and the tether looks stretchy. In 48% of years, stocks have not gone up as fast as inflation. In 38% of five-year periods, stocks have lagged inflation. Some 42% of 10-year periods have failed. About 33% of 20-year periods have disappointed. In 24% of 30-year periods, inflation has stretched away faster. So for most of us inflation does matter.

Inflation has a complex relationship with stocks: none of it is awkward, some of it is good, too much of it is bad. When inflation is controlled and sits between 1% and 4% a year, the stockmarket tends to do well. Stocks, on average, go up 7% a year when inflation is well-behaved.

The watershed inflation rate for stocks seems to be 4%. When inflation gets above 4%, stocks struggle to keep up. The average rise in stocks when inflation settles in the 4-10% range is only 4.7%. Inflation above 10% is also too fast for stocks to keep up – stocks go up but at a slower rate (6.4%) than when inflation is well-behaved. When inflation is less than 1%, stocks struggle, managing an average annual rise of 0.7%. Total return is still good in no inflation periods because stocks pay dividends but their value hardly goes up at all.

Which way inflation is moving matters as well. Stocks like well-behaved inflation. When this year’s inflation is within 1% of last year’s inflation, stocks make hay – on average they have gone up by 8.4% a year. Stocks also do well when inflation is being tamed. In years when inflation has decelerated by more than 1%, stocks have gone up, on average, by 6.7%.

What stocks do not like is accelerating inflation. If inflation starts to accelerate by more than 1%, stocks barely move (averaging only 0.9%). This is when the elastic gets really stretched.

From history, it is possible to conclude two things. Inflation hurts when it gets above4% and/or when it is accelerating. This is why I care about inflation at the moment.

About a year ago, I began to notice inflation in my stocks. Companies do not talk about inflation. They phrase its impact differently. If a company is benefiting from inflation, it talks about “pricing power”.

Pricing power has been returning to areas from where it has long been absent. There are a few industrial companies that laboured through the 1990s, finding it almost impossible to raise prices, but now find they have pricing power.Commodity stocks are essentially riding the same theme.

The inflation theme is creeping into more sectors of the market. I own almost no companies that complain of “cost pressures”, the wail of companies that suffer from inflation.

I have spent time digging out more stockmarket history. If you look at stockmarket statistics going back over a century, the numbers reveal a beautiful symmetry. The average total return for British stocks is 9.2%, half from income (4.6%) and half from capital (4.6%).

One of the key indicators I look for in the stocks I buy is the equity risk premium. This is the excess yield offered by stocks over the yield of either conventional gilts or index-linked gilts to compensate for the risk of potential capital loss of equity investments. For example, over the past 100 years, the real yield on gilts has averaged 2.5% and the dividend yield on stocks has averaged 4.6%, so the equity risk premium has averaged 2.1%.

If investors buy stocks when the risk premium is below 2%, their returns tend to be disappointing. For those who buy stocks when the risk premium is above 2%, the returns tend to be good.