Can stocks provide a hedge against inflation?

It has been said that the stock market tends to perform poorly during periods of rising inflation because higher inflation often leads to higher interest rates.

When interest rate increases, the cost of capital of companies also increases, which pressures stock prices to fall because of lower valuations.

Market history will tell us that the movement of interest rates, as represented by the 10-year Philippine bond yield, is negatively correlated with the Philippine Stock Exchange (PSE) index 72 percent of the time for the past 22 years.

It is not surprising that when inflation rate increased to 4 percent last month from 3 percent in February, the 10-year bond yield also accelerated to 6.09 percent from 5.26 percent the previous month.

The rise in the 10-year bond yield due to expected higher inflation caused the PSE index to lose as much as 500 points by end of April.

Last week, the Philippine Statistics Authority reported that the latest inflation figure in April continued to increase to 4.9 percent, triggering the 10-year bond yield to rise further to 6.18 percent.

The rise in interest rates along with inflation is expected to raise market volatility in the coming weeks, which could send the PSE index falling to lower lows.

If inflation could cause the stock market to fall, why does conventional wisdom always suggest that stocks are good defensive assets that provide protection against inflation?

In 1981, an American professor from the University of Chicago by the name of Eugene Fama explained that the negative relationship between stock returns and inflation is not direct, but rather, inflation negatively impacts the activities in the economy, in turn affecting the stock market.

Fama posited that inflation indirectly affects the stock market through the various economic variables that it influences, such as interest rates, rate of returns and capital expenditures.

If we look at historical data since 2000, we will find that inflation has an inverse relationship with the PSE index, similar to the interest rate, but has a weak negative correlation of only 17 percent, which confirms Fama’s proxy hypothesis.

Flexing pricing power

Because stocks are linked to companies that can adjust their prices to offset rising input costs, we can expect companies to see their revenues and earnings grow over time.

Higher earnings brought about by inflation means higher nominal growth, which translates to higher share price appreciation in the future.

If we compute the compounded annual growth rate of the consumer price index since 1987, we will find that the average annual inflation over the past 34 years was 6.32 percent.

But if we compare this against the annual growth rate of the PSE index during the same period, we will find that stocks generated a higher return of 8.07 percent, yielding a positive inflation-adjusted return of 1.75 percent.

Now, not all stocks can generate returns above inflation because not every company has the same capacity to raise prices.

Some companies are able to adjust their prices quickly before their costs catch up with them, because they have stronger pricing power, while some are slower to raise prices due to competition.

For example, if you bought the stock of Ayala Corp. in 1987, your compounded annual return on the stock by end of 2021 would have been 13.5 percent, which was more than double the annual inflation rate of 6.32 percent.

Because your returns were greater than inflation, your annual real return on your investment would be a positive 7.19 percent per year.

On the other hand, if you bought Philex Mining in 1987, which had no pricing power in the gold market, you would get a lower compounded annual return of only 3.63 percent.

Since the average annual inflation of 6.32 percent was higher than your returns, you would get a negative real return of 2.69 percent per year, giving you cumulative losses in purchasing power.

While it is true that stocks can suffer when inflation spikes in the short-term, stocks, in general, can offer good inflation hedge in the long-term.

Current weakness in the stock market brought about by inflation should offer good opportunity to buy quality stocks that can generate strong returns in the future.

In a rising inflation environment, it is always important to choose stocks that are not only able to sustain their growth over time, but also have the ability to pass along higher input costs to their customers. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email [email protected] or text at 0917-6248110.