Stocks as protection against inflation - August 12, 2022

Stocks as protection against inflation
Inflation has hit the headlines over the last few months. The phenomenon is worldwide. In June 2022, consumer prices in the euro area rose by 9.6% compared to the year before. This is the highest inflation rate in the eurozone’s 23-year history. In the United States, consumer prices were up 9.1% during the same period. That is the highest inflation rate in four decades. The big question for investors is: can a stocks portfolio protect them against inflation?

Equities have traditionally been considered as an inflation hedge. The theory is quite simple: the revenues and earnings of a company would also increase with inflation. Does this theory hold true?

To answer this question, we have analyzed the US stock market data used by Robert Shiller, a Nobel laureate in economics and professor of economics at Yale University, in his book, Irrational Exuberance. The dataset covers the period from early 1871. We examined the 12-months trailing returns of the US stock market (including dividends) adjusted for inflation (see Chart 1).

We discovered that the stock market outperformed the inflation in 69% of the cases. Furthermore, the ability of an equity portfolio to hedge against inflation increases with the length of time an investor holds the portfolio. For example, if we look at the 5-year trailing returns, the stocks outperformed the inflation in 81% of the cases. 

We also examined the whole period covered by the dataset (151 years). The average return for the US equity market, including dividends, was 9.1%. Inflation averaged 2.1 per cent over the same time period. This translates to an inflation-adjusted average return of 6.9%, including dividends. As a result, over the long term, equities can be viewed as an excellent inflation hedge.

Chart 1 also shows that equities underperform during periods of higher inflation. Research shows that unexpected inflation is very bad news for equity investors. It is therefore important to emphasize again that equities protect against inflation in the longer term.

Of course, equities are not the only asset class that is considered an inflation hedge. You can take into account assets such as real estate, commodities, gold, treasury inflation-protected securities TIPS. Still, according to Investopedia, many analysts and economists feel equities are a better way to protect your portfolio against inflation over the long term. 

The bottom line

Many analysts and economists believe equities are a better way to hedge your portfolio against inflation over the long term. The evidence confirms that equities provide excellent long-term inflation protection. However, in times of unexpected increase in consumer prices, stocks may show a poor performance. In times of rising inflation, investors should therefore remain patient and disciplined and let their equity portfolios work towards their long-term goals.

Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.