Inflation has reared its ugly head as the next big risk to global financial markets, replacing systemic financial sector risks, post the Bear Stearns bailout. Investors are now more worried about oil and grain prices than the possibility of another large financial institution going bust. With oil prices at $125, and commodities across agricultural products, metals and minerals at elevated price points it is no wonder that inflation is now probably the biggest bugbear of investors, certainly in the emerging markets.
It is easy to understand investors' fears of inflation, as history consistently shows that high inflation environments are very unkind to financial assets. If you look at the decade of end-1969 to end-1979 (a period of high and rising inflation), equities delivered consistent negative real returns in both the US and UK (source: BZW). While weak, equities at least delivered better returns than bonds, which got totally decimated in this type of an environment.
The source of the poor performance in equities was not corporate earnings, as earnings rose in real terms throughout this period. Profits were able to outperform high inflation. The source of the poor returns was a structural compression of the PE multiple. As an example, the PE multiple for the S&P 500 started the decade of the 70s at 16 and ended the period closer to 7. It is almost impossible for equities to be able to deliver positive real returns when you face multiple compression of this magnitude. There is a clear and strong negative correlation between inflation rates and PE multiples.
What causes this compression and why is it structural?
The one obvious answer is that high inflation will trigger a rise in system-wide interest rates as central banks will be forced to tighten monetary policy to combat rising prices. Rising interest rates raise your opportunity cost of capital, and thus PE multiples have to adjust to raise the expected rate of return in equities to make it comparable to what is available in fixed-income markets. Also as rates rise they have a larger impact on long-duration assets like growth stocks and real estate, where multiple compression is the maximum as their cash flows tend to be more back-end loaded. Negative cash flow stocks have the toughest time of all.
The second reason for the PE compression is also the heightened economic volatility associated with a highly inflationary environment. Economic growth becomes more uncertain and the volatility of economic growth tends to rise and fall with inflation, including profit volatility. The need to control inflation through lowering aggregate demand can lead to recessions and sub par economic performance. We may also see muddled government policy and interventions in micro industry level pricing, which reduces economic predictability. With the economic and profit environment becoming more volatile, investors will typically demand a higher risk premium for perceived greater risk to earnings and cash flow. This higher risk premium translates into a higher earnings yield or lower PE multiples.
Another reflection of greater risk is the fact that in the high inflation environment of the 70s, the distribution of profits and profit growth across sectors also narrowed significantly. Significant positive real earnings growth was delivered only by a few sectors, primarily oil & gas and financials. With such a narrow dispersion of profits, the perceived risk to corporate earnings rises.
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High inflation is an unambiguous negative for financial assets, PE compression being the overpowering dynamic that trumps everything else.
The question we have to ask ourselves is whether we are truly entering a new higher inflationary environment.
It is currently tempting to describe the commodity rallies as highly speculative and bubble-like. A significant portion of current market opinion believes that what we are seeing in the commodity complex today is strong buying driven by speculative flows out of financial markets. Many of the more savvy players in this space are now coming around to the view that this may not be the whole truth. They point to the huge price spikes in commodities like cobalt, tungsten and manganese and many others where financial investors have almost no exposure or role to play. If financial speculation is behind the commodity move, how can one explain why these so-called inaccessible commodities have actually risen as much or more than widely traded metals like copper and aluminium?
The answer lies in rapid and sustained demand growth coming up against a surprisingly unresponsive supply side. In commodity after commodity (not just oil) we are seeing disappointing supply, in spite of prices being at levels that ensure strong financial returns to new projects.
This type of commodity-based inflation is a much greater risk to the emerging markets as their price indices will typically have a much higher weight for such basic inputs than in the OECD countries. The ability of their populations to absorb such hikes in prices of basic inputs is also far more limited. The structure and sophistication of most of the EM economies and their manufacturing base is also such that commodity price impacts have greater influence on margins than in the typical OECD economy. In the midst of a huge infrastructure build-out, the EMs are also facing enormous cost escalations as the commodity spike has raised their costs.
While I am sure we will see some correction in the commodity complex and definitely in oil, there does exist the strong possibility that we are in a new price zone for most basic inputs. This will be a strong negative for most of the EMs and countries like India, which are large importers of oil and many other commodities and where consumption is rising structurally.
India also has the additional problem: As prices of commodities like fertiliser and oil keep rising, we continue to create a bigger and bigger hole in the fiscal. A rising and unsustainable subsidy burden will pressure the fiscal deficit, raise interest rates and ultimately spill over into inflation. Rising interest rates, like inflation, are a killer for multiples and ultimately economic growth. India, already running a large fiscal deficit, has very limited ability to absorb a further spike in subsidies, and seemingly limited political will to tackle these issues.
Inflation is the new variable we should focus on. If you believe that commodity prices will come down, we are probably set up for a strong rally in financial assets, especially the EMs. If you believe that prices and inflation will remain elevated, all financial assets will have a difficult period ahead.