mawer INSIGHT INFLATION: The Influence of Inflation on Equity Returns IN THIS ISSUE

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1 mawer INSIGHT Volume 34 May 2011 INFLATION: The Influence of Inflation on Equity Returns IN THIS ISSUE The Basics Is Inflation Bad for Equity Returns? Developed Market Stock Returns vs. Inflation Rates What is a Good Inflation Hedge? Developing Market Stock Returns vs. Inflation Rates Is Deflation Bad for Equity Returns? Copyright 2011 Mawer Investment Management Ltd. Readers may forward electronic versions of this article. To order reprints or receive an electronic copy, please contact us at info@mawer.com

2 2 Volume 34 May 2011 INFLATION: The Influence of Inflation on Equity Returns Is inflation bad for equity returns? Is deflation bad for equity returns? Should I be selling my U.S. stocks if the American Consumer Price Index (CPI) is high? If there are high inflation rates, should I be buying stocks? In this article we will review how inflation affects equity investments, and we will find that there are no set investment rules when it comes to inflation. THE BASICS Each investment in a bond or stock is a claim on a series of future cash flows. These can be coupon and principle payments for bonds, or earnings for stocks. Inflation reduces the purchasing power of cash and, therefore, reduces the value of such future cash flows. If investors expect inflation to be high in the future, then they require higher rates of return today. This relationship is most easily observed in bond investments. All else being equal, bond yields will increase as inflation expectations increase. The higher yields result in lower bond prices in secondary markets, higher coupons on new issues, and higher reinvestment rates for the interest received. While this relationship is fairly straightforward, how inflation affects equity investment returns is a much more complex topic and subject to disagreement between experts. Unlike a bond, the future cash flows of an equity investment are not limited to the coupon stipulated in an offering document. To understand how inflation may affect returns for an equity investor, one has to postulate how inflation affects future company earnings and dividends. Although higher future prices bode well for revenues as a company can increase charges to its customers for its products and services, higher prices are also likely to increase its wages, borrowing rates, raw materials, and rent. Thus, while the company increases its sales, it also must pay more to operate. IS INFLATION BAD FOR EQUITY RETURNS? Equity investments, along with real assets such as commodities or real estate, are often said to be an inflation hedge. This term refers to an investment with rates of return that are greater than, or equal to, the rate of inflation. As costs increase, a company will try to pass these expenses on to its customers, thereby increasing revenues and maintaining net cash flows. The result is that cash flows are protected from the affects of inflation and continue to accrue to the equity investor. Unfortunately, this depiction of stocks is incomplete. It is common to measure inflation with indices based on averages of prices of consumer products such as the Consumer Price Index (CPI). But costs and sales for a single product or company will increase at different rates than those shown by the indices, and the ability of each company to mitigate increased costs by increasing sales will vary. If a company cannot increase revenues to fully compensate for increases in its costs, the profit margins for its shareholders will decline. The higher and more volatile inflationary rates become, the more companies are at risk for declining margins. Clearly, the term inflation hedge is undeserved for many companies. Inflation can also create headwinds for equity as an asset class. Higher inflation expectations increase interest rates which in turn increase the yields on bonds. When an investor buys stocks, they expect a rate of return higher than if he or she bought bonds. It follows that to maintain a current stock price when investors have high expectations for inflation, the expected rate of return for equity investments must also increase to compensate for the relative value of bonds. But, even if a company has the good fortune to be able to pass 100% of its cost increases to its customers, this does not necessarily translate to an increase in profit margins or an increase in the rate of return for shareholders. All things being equal, it would appear that higher inflationary expectations will tend to depress stock prices and reduce shareholder returns. For example, let us hypothesize that inflation rates are very high, 10 to 20%. High and volatile inflation rates tend to increase inflation expectations so that interest rates become prohibitively high for equity investments. Imagine that a Government of Canada bond yields 15% because inflation expectations are near 12%. A high quality corporate bond issue would contain greater risk than the government bond, and must yield over 15%, say 17%. For a shareholder of the same corporation, the return on their equity must yield over 17% to compensate for the increased risk of holding stock rather than a corporate bond. Because there is nothing about an inflationary environment that necessarily leads to increased company profitability and return on equity, the stock price may have to decline to entice buyers with higher expected returns. DEVELOPED MARKET STOCK RETURNS VS. INFLATION RATES Admittedly, we have painted a negatively biased picture for stock returns as they relate to inflation. A review of two major equity indices, the S&P/TSX Composite Index and the S&P 500, provides some evidence as to why many call for buying equity as protection from inflation. In Figure 1, we have taken the difference between 10 year annualized total returns for the S&P/TSX Composite Index and 10 year annualized Canadian CPI rates. For the past 15 years, equity returns for this index have convincingly outpaced Canadian CPI increases. In fact, since 1995 the S&P/TSX total returns have exceeded CPI by 7.5% on average. This period in Canada has been characterized by relatively low, stable inflation. In the late 1980s and the early 1990s, inflation was much higher and more volatile, and equity annual rates of return above annual inflation

3 Volume 34 May rates were not as common. As demonstrated in Figure 1, stocks do not provide much inflation protection during this period. In 1990, a person invested in the S&P/TSX Composite Index would have failed to beat inflation rates over the past 10 years % % 6.00% 4.00% 2.00% -2.00% -4.00% Jan-87 Jan-88 Figure 1 Source: Bloomberg In the U.S., the past 20 years are characterized by stable, low inflation while the 1970s show mostly high, volatile inflation rates. Figure 2 provides complementary analysis to Figure 1 using total returns of the S&P 500 and U.S. CPI values. 10 year equity returns failed to beat inflation rates in the early 1980s, but throughout the 1990s, and much of the new millennium, equity returns provided growth above inflation rates. It is important to note, however, that an investor in the S&P 500 Index would have failed to beat inflation over the past 10 years as of the end of 2008, 2009, and % % -5.00% Figure 2 Source: Bloomberg The Difference Between 10 Year Annualized S&P/TSX Composite Total Rates of Return and Year Over Year Canadian CPI Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 What can we learn from this analysis? Over the past 30 years, observed equity returns have exceeded inflation rates and provided growth in the purchasing power of assets most of the time. During this period, equity, as an asset class, can be generally described as a good investment to beat inflation. Be that as it may, equity investments are not surefire inflation hedges. When 10 year average annual inflation rates have Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 The Difference Between 10 Year Annualized S&P 500 Total Rates of Return and Year Over Year US CPI Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 been between 5 and 10%, there is a greater risk that equity returns will not outpace inflation rates. This was the case in the early 1970s for the domestic U.S. investor and in the early 1980s for the domestic Canadian investor. WHAT IS A GOOD INFLATION HEDGE? There are a few ways to invest in equity and reduce the risk that inflation presents. The key is in investing in companies with the right business model and in understanding how inflation expectations affect stock prices. Some businesses may find themselves benefiting from higher interest rates. A good example of such a business is Manulife Financial Corporation. Insurance businesses benefit from increased profits when interest rates are greater than those assumed in their previously written insurance policies. Trust companies can also exhibit similar characteristics. Aside from the type of business, we need to understand the difference between investing in a company and investing in the stock of a company. Expectations about inflation can affect stock prices to compensate the equity investor for inflation. Consider if the general market consensus is that inflation will be 2% on average over the next 10 to 15 years. If I buy a stock at fair value today, the price of the stock will already have factored in the 2% inflation rate. If inflation expectations suddenly jump to 5%, then there is a greater chance of the stock price declining. If I buy a stock at fair value when the expectations for inflation are 5%, then a realized 5% inflation rate does not have the same negative effect on the stock price. Overall, some stocks can be considered a good inflation hedge. The keys are to find the right business model and to purchase a stock at a price that adequately considers inflation expectations. In this way, an investor can protect his or her portfolio or even benefit from an increase in inflation expectations. DEVELOPING MARKET STOCK RETURNS VS. INFLATION RATES The relationship between inflation and equity returns increases in complexity for the international investor. Figure 3 below expands on the analysis above using the equity market of Brazil. Brazil was chosen as an example because of its prominence as an emerging market and the extreme annual inflation rates Brazil has experienced in the past.

4 4 Volume 34 May 2011 In Figure 3, the first graph compares 10 year annualized total Brazilian real returns for the Bovespa Index with Brazilian CPI. Like developed markets, Brazilian equity returns as measured by the Bovespa Index generally exceed inflation rates. The second graph in Figure 3 depicts the difference between the 10 year annualized Bovespa Index total returns in Canadian dollars and Canadian CPI. It would appear that Brazilian equity, on average, has provided an inflation hedge to the Canadian investor over the past seventeen years % 16.00% 14.00% 12.00% % 6.00% 4.00% 2.00% -2.00% The Difference Between 10 Year Annualized Bovespa Total Rates of Return (BRL) and Year Over Year Brazilian CPI hedge. High inflation in a foreign country will reduce the value of its currency relative to our own, all else equal. This has a negative affect on Canadian Dollar returns. Given this increased risk, Brazilian equity was not an effective inflation hedge when compared to investing in Canadian equity alone. In addition, notice that only 10 year annualized rates since 2004 have been included in the graphs. Reliable and accurate measurement of inflation and equity returns in Brazil are difficult to obtain prior to 1994, when the current Real was adopted as the currency of Brazil. The difficulty arises because prior to 1994 Brazil experienced a number of years of extremely high inflation rates. For example, the annual inflation rate in 1993 was well over 2,000%! Such extreme, runaway inflation rates are often termed as hyperinflation. With this kind of inflationary changes, measurements like CPI are significantly biased and hence it is difficult to create comparisons like the ones for the S&P/TSX Composite and the S&P 500 indices % 1 The Difference Between 10 Year Annualized Bovespa Total Rates of Return (CAD) and Year Over Year Canadian CPI Hyperinflation is a significant risk in developing markets such as Brazil s. Its effects and causes are subject for an entire article on its own, but two comments can be said here: 8.00% 6.00% 4.00% 2.00% 1) hyperinflation negatively affects trade and productivity in an economy such that many equity investments would be at serious risk of capital loss, -2.00% 2) holding a currency that rapidly depreciates in value is not desirable to say the least. Figure 3 Source: Bloomberg At first glance, a Canadian investor buying Brazilian stock does not appear to be at a disadvantage in comparison to a Canadian investor buying Canadian equity, however, there is more to the story than what is shown in these graphs. The Bovespa Index Brazilian Real total returns have outpaced Brazilian inflation rates to a greater extent than the same index Canadian Dollar returns have outpaced Canadian inflation rates. For most of the time period examined, the Brazilian Real was weak against the Canadian Dollar. This is the challenge for international investors: exchange rate movements may reduce the effectiveness of the inflation The international investor can also note that the opposite of the above scenario with Brazil, is also true. If domestic inflation rates are higher than inflation rates of a foreign country, then the value of the foreign currency will appreciate relative to domestic currency, all else being equal. This has a positive affect on returns and enhances the ability of equity, or any other investment in the foreign currency, to exceed domestic inflationary rates. SUMMARY There is always a risk that returns on equity investments insufficiently grow above inflation rates. When inflation is low and stable, stock prices can adequately adjust for inflation expectations. As inflation

5 Volume 34 May rates increase or unexpectedly rise, the ability of equity returns to rise above inflation rates is reduced. In Canadian and U.S. equity markets, this risk was realized after the high inflation rates of the 1970s and 1980s. With international investing comes exchange rate risk, which could be negative or beneficial to equity returns and their inflation hedging ability. We can conclude that holding equity over the past 15 years has, in most times, been a good way to beat low to moderate inflation rates. A review of market returns, however, may call into question whether or not equity can be accurately called an inflation hedge. An active investor can take a few steps to find good inflation hedges in international equity markets. First find a business model that is less susceptible to negative affects of inflation. Second, build inflation expectations into the value of the stock. Finally, evaluate the inflation environment of the foreign economy in addition to the domestic one when investing internationally. IS DEFLATION BAD FOR EQUITY RETURNS? There is little experience in financial markets with deflationary economies. From what has been observed, many believe that deflation has led to losses in stock markets mainly due to debt A consumer can separate the time when a good is consumed and when he or she pays for that consumed good by borrowing cash at the time of consumption. Over the time of the loan, a proportion of wages must go to paying for past consumption, thereby reducing current consumption. If there is a general increasing trend amongst all consumers toward paying past debts, overall demand for goods will decline, which will result in a price decline. A reduction in aggregate demand is not a good sign for corporate profitability and over time should lead to lower stock returns created. In its extreme form, sometimes called debt deflation, the cycle can lead to a price decline similar to the Great Depression or what was observed in In this case, deflation is coupled with a major contraction in production that reduces profits and plunges the prices of stock. In this case, deflation is definitely bad for equity returns. Others worry that deflation is a signal of economic and stock market conditions similar to that of Japan. Figure 4 sums up the Japanese equity investor s experience over the past 40 years. From 1971 to 1989, there was only one year, 1986, where the Japanese experienced deflation rather than inflation. 100 invested in the Nikkei 225 Average at the start of 1971 would be worth 1958 at the end of Japanese CPI increased at an annualized rate of 5.1% over the same period. The next 20 years tell a strikingly different story. 100 invested in the Nikkei 225 Average at the start of 1989 was worth only 31 at the end of Japanese CPI turned from inflation to deflation early in this period with an annualized rate of 0.4%. From the start of 2000 to the end of 2010, the annualized rate of inflation (deflation) was -0.2%. Annual Japanese CPI and Annual Nikkei 225 Total Return (Yen) Japan CPI Nikkei 225 Annual Canadian CPI and Annual Nikkei 225 Total Return (CAD) If inflation reduces the value of 10 currency then deflation increases its 0 value. This provides an incentive to -10 further delay current consumption -20 in favor of debt payments for past -30 consumption because the dollars used for debt payments are worth -40 more every day. The reduction in current consumption places further downward pressure on prices. Thus, a positive feedback cycle is Canadian CPI Nikkei Figure 4 Source: Bloomberg

6 6 Volume 34 May 2011 There has been little growth of the Japanese economy since the start of 1990, which means that there has been little growth in corporate profitability. This helps to explain the poor returns of the stock market. Since this poor growth and equity returns have happened at the same time as the Japanese economy transitioned from an inflationary to a deflationary economy, it would appear that the two are linked. If this is truly the case, then deflation is the harbinger of poor equity returns, and the purchasing power of an investor s portfolio will increase only by holding cash or bonds. An interesting analysis that runs counter to these fears was provided in the revised edition of the Intelligent Investor by Benjamin Graham with additional commentary by Jason Zweig published in Zweig reproduces part of a study from Ibbotson and Associates 2003 Stocks, Bonds, Bills, and Inflation Yearbook. He reports that since 1926 to 2002, there were 10 deflationary years in the US. In three of these years, deflation was under -5% and stock returns were well beneath -20%. These appear to be the extreme debt deflationary scenarios as described above. In six of the other seven years, stock market returns exceeded 10%, with the highest two annual returns over 50%. In the final deflationary year, stock returns and inflation annual rates were near 0%. From these U.S. observations, it would appear that mild deflationary rates have not always resulted in negative stock market returns. In A Monetary History of the United States Milton Friedman and Anna Jacobson-Schwartz provide observations that also challenge the link between deflation and declining productivity. A secular deflationary trend persisted in the U.S. for approximately 30 years following the Civil War. However, to quote the authors when comparing this deflationary period with the inflationary 20 years after it: Deflation appears to be negative for stock returns as it relates to a debt deflation cycle of a serious recession because it creates incentives that deepens that recession. Outside of this scenario, it is difficult to determine if a deflationary economy is a negative for equity markets. MAWER S TAKE ON IT Mawer creates broadly diversified portfolios of wealth-creating companies bought at a discount to our estimate of their intrinsic value. As aforementioned, it is important to adequately build inflation expectations into the value of a stock. Purchasing stock at a discount to its intrinsic value help us provide a degree of protection against unexpected changes in inflation. By purchasing high quality businesses with strong competitive advantages, the companies in our portfolio are also more resilient to prolonged and severe recessions that accompany a debt deflation cycle. Our strategy helps to protect the value of our equity portfolios over the long-term. A part of our investment process is to regularly review the risks of inflation and deflation and make adjustments to our portfolios accordingly. These adjustments may include favouring one stock over another or implementing a shift between asset classes. Additionally, we diversify our investments globally in order to mitigate the risk of exposure to any one particular country s inflation rate volatility. Gavin Preston, CFA Portfolio Manager, Private Client Portfolio Management Mawer Investment Management Ltd. In the two final decades of the nineteenth century [there] was a growth of population of over 2 per cent per year, rapid extension of the railway network, essential completion of continental settlement, and the extraordinary increase both in the acreage of land in farms and the output of farm products manufacturing industries were growing even more rapidly.a feverish boom in western land swept the country during the eighties generally declining or generally rising prices had little impact on the rate of growth.this evidence reinforces the tentative conclusion reached that the forces making for economic growth over the course of several business cycles are largely independent of the secular trend in prices. 1 Graham, B., & Zweig, J. (Revised 1973 edition) Intelligent Investor. HarperBusiness Essentials, 2003, p Friedman, M., & Jacobson-Schwartz, A. (1971). A Monetary History of the United States New Jersey: Princeton University Press. All information contained herein has been collected and compiled by Mawer Investment Management Ltd. All facts and statistical data have been obtained or ascertained from sources, which we believe to be reliable but are not warranted as accurate or complete. All projections and estimates are the expressed opinion of Mawer Investment Management Ltd. and are subject to change without notice. Mawer takes no responsibility for any errors or omissions contained herein, and accepts no legal responsibility from any losses resulting from investment decisions based on the content of this report. This report is provided for informational purposes only and does not constitute an official opinion as to investment merit. Based on their volatility, income structure or eligibility for sale, the securities mentioned herein may not be suitable for all investors.