The return of inflation – equities are an imperative

Inflation has been picking up worldwide for some months now. For example, the price hike in the USA recently reached 2.5%, the highest figure since 2012. In Germany, prices rose by 1.9% as at the end of January – a level last seen in 2013. It is not really surprising that the buzzword of “reflation”, meaning the return of inflation, triggered both by monetary and fiscal policy hitting a more expansionary gear and by rising commodity prices, is doing the rounds again. Specifically German citizens are disproportionately exposed to such fears, not least owing to the negative reports on hyperinflation in Germany just short of a century ago.

For many years, dividend-bearing securities had the reputation of being inflation-proof investments. However, were the suitability of equities as a hedge against inflation to be true, then price trends for shares in periods of high inflation should be correspondingly better than at other times. This is an erroneous assumption, as our studies of the US stock market for the period 1871 to 2008 show. Equities prove to be resistant in periods of moderate inflation, but not if economic growth is stagnating or negative.

On balance, inflation can impact negatively on equities in various ways. Their profitability dwindles as the costs rise and cannot immediately be passed on to the clients. In addition, investors expect a higher risk premium in phases of inflation or inflationary uncertainty. The fair value of the shares falls accordingly. Investors may also prefer other investments, such as property or precious metals, meaning so-called “hard assets”.

A phase of high or persistent inflation would not be something new for the stock markets to face. In the periods 1916-1920 (financing the First World War) and 1973-1982 (the oil price shock) prices actually shot upwards.

In Germany, inflation has run at 2.3% a year since the Currency Reform of 1948. If one takes this historical benchmark for inflation and extrapolates it into the future, then in 30 or 50 years’ time citizens will in real terms have forfeited half or 68% of the current purchasing power of the Euro. In other words, inflation is one of the key opponents that investors need to keep in check – alongside other elementary aspects such as personal mindset, costs and taxes.

By contrast, after adjusting for inflation over the past 50 years German equities (“genuine” DAX stocks first came into existence in 1987) grew by 6.0% (or a nominal 8.3%) per annum, including the reinvested dividends. It would seem advisable in future to rely more strongly on equities as a hedge against inflation. Companies with price-setting power or offering strong value potential, property corporations and firms that possess commodities that cannot be replaced at random should all prove to be more resistant to inflation. And equities that regularly disburse a high and secure dividend also belong in this investment universe.

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