Let me start this discussion by quoting Warren Buffett.
Warren Buffett wrote How inflation Swindles the Equity Investor in 1977. That year the annual inflation rate was running at 7%. The average inflation rate over the preceding 7 years was also close to 7%, going as high as 11% in 1974. Over the next 4 years it would average close to 11% per year.
Buffett’s main takeaway is that stocks are more similar to bonds than most investors assume, especially when it comes to investing during a highly inflationary environment:
The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
Buffett’s reasoning here was based on the idea that return on equity for U.S. corporations is relatively stable over time at around 12%. ROE measures how much profit corporations generate for every $1 of shareholder equity.
Obviously, the prices people are willing to pay for that ROE can vary quite violently at times, but ROE itself is relatively sticky.
Using this framework, you can think of stocks as something of a perpetual bond that never comes due.
If ROE on stocks doesn’t change all that much, higher inflation would be harmful since investors would be receiving a lower share of profits after accounting for a higher cost of living.
Buffett also explained in the book:
Even if you agree that the 12% equity coupon is more or less immutable, you still may hope to do well within the years ahead. It’s conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variables: the relationship between book value and market value, the tax rate, and the inflation rate.
So there we are: 12% before taxes and inflation; 7% after taxes and before inflation, and maybe 0 percent after taxes and inflation. It hardly sounds like a formula that will keep all those cattle stampeding on TV.
AS common stockholder you will have more dollars, but you may have no more purchasing power.
Unfortunately, this means high inflation can be bad for both stocks and bonds.
Interestingly enough, even on a nominal basis the year is off to a poor start for both stocks and bonds:
We’re only a few weeks into the year so it’s a little premature to draw any concrete conclusions but if this were to hold it would be one of the few times both stocks and bonds have both finished the year in negative territory.
Over the past 90+ years, there are only 4 years where both stocks and bonds fell in the same year in the U.S. markets:
The weird economic state of affairs we find ourselves in this year with high inflation and rising rates from low levels is the perfect environment for this to happen.
Two of these four years included years with above-average inflation (5% in both 1941 and 1969).
The questions investors have to ask themselves are the following:
- Does it really matter?
- Does the potential for an underwhelming year mean you should abandon traditional diversification?
- Should you change your portfolio under an inflationary scenario?
- What if high inflation doesn’t stick around?
But, keep in mind that the stock market is still one of your best bets for hedging against inflation over the long run but a sustained run of higher prices can put a dent in stocks in the short-to-intermediate term.