Despite what many may think, equities are not a hedge against inflation, writes Dr Stephen Nash.
In this article we consider the current political climate in the United States, and at home, in some detail, before looking at a format of fixed income that has extremely strong diversification benefits for an investment portfolio as a whole.
Specifically, we:
- Analyse the current policy environment, both in the US and in Australia,
- Consider how the policy environment is starting to drive economic outcomes; and
- Consider the portfolio construction implications of not having inflation-linked bonds.
Policy environment
Political risk remains despite the deal in the US executed mid-October. Specifically, the debt ceiling will be raised until 7 February 2014, while the Government will be funded until 15 January 2014.
However, the consequences of the debt wrangle linger:
- Government shutdown and impact on the economy: There is no one definitive estimate of the cost of the past government shutdown – be they direct taxpayer costs taken for paying salaries that delivered no value, or the indirect costs, which are much larger. While estimates vary, Standard and Poor’s estimated the cost on the US economy to be roughly 60 basis points off annual GDP growth, or around US$24 billion.
- Fiscal lever now eliminated: No matter what the Democrats do they remain unable to foster any new fiscal initiatives, mainly because of the ardent position of the Republicans, so the US economy continues to suffer from the impact of the existing sequester.
- Wrangle to drag growth lower in the current quarter: Participants in the economy will change economic decision-making as a result of the deal. Expansion plans will be trimmed on the supply side of the economy, while holiday spending will be moderated on the demand side of the economy. With less investment and less spending, it is likely that economic growth will be fairly slow this quarter. Hence the 60 basis point cut in terms of GDP from the shut-down is just the start of the impact on growth.
Meanwhile, in Australia, the economy remains at sub-trend growth, as the economy tries to rebalance from mining-led growth to non-mining-led growth. As the post-election growth spurt takes shape, it can be anticipated that some financial market forecasters will anticipate a tightening of monetary policy in Australia.
However, we anticipate that these calls will not be headed by decision-makers at the RBA, who will need to see confirmation of any new growth before changing policy direction.
After some time, settlement of growth should occur back towards sub-trend levels and this should allow the RBA to act on the current forward guidance; ie, for the RBA to ease again in 2014. Also, we anticipate that the very moderate readings of underlying inflation in the recent CPI release should allow plenty of scope for the RBA to further ease monetary policy.
Policy environment and economic surprise
Given the above drags on growth, it would be interesting to see if the policy environment is beginning to impact the economy.
A useful tool for assessing this impact is the Citigroup suite of Economic Surprise indices.
These indices are quantitative measures of how actual economic news compares to the survey of forecasts, as provided by Bloomberg.
While a positive reading of the Economic Surprise Index indicates that releases are better than expected, the reverse is also true. Figure 1 shows releases are quite volatile relative to expectations.
More recently, we can see that the Index has begun to turn down, meaning that releases are starting to come out weaker than expected, especially since September 2013.
Among other things, this suggests the anticipation of the recent US political wrangling has already had a negative impact; more is to come.
Inflation risk and equity return
If the political environment is not supportive of growth, as we suggest in section 1, and if that decline in growth is being reflected in economic releases, as suggested in section 2, then investors needs to review the relationship of share performance and share return.
Specifically, if share performance suffers, then investors cannot use these securities to fund retirement spending.
Moreover, as income falls the investor faces a greater exposure to inflation, as more of total income is spent on the volatile components of the CPI.
In order to analyse the relationship between annual share or equity return and annual inflation, we use US data as we can examine a longer period, with both US equity returns (using the S&P 500) and the US CPI available from 1951.
Firstly, we review the annual return series for both US equities and for US annual inflation, as shown in Figure 2. Note how annual equity return is not only volatile but that it generally tends to move in the opposite way to annual inflation.
Note, in particular, where inflation rose due to oil price rises in the 1970s, and how equity returns failed to move with inflation.
Hence share returns tend to have a negative correlation (meaning they don’t move in the same direction at the same time) with inflation; the opposite of what retirees need and what most investors expect. Such a negative relationship makes sense from a logical point of view, as follows:
- When inflation is high, interest rates rise and constrain growth, so growth suffers and so does annual equity performance.
- When inflation is low, it becomes apparent to market participants that the economy is not impeded by high interest rates, so growth is higher and equity performance is higher.
Another way to assess correlation is to consider rolling annual return correlations over different rolling periods.
For all the periods we used, from rolling one-year, to rolling 10-year, the average correlation remains negative.
This is also true for the total period, with over 15,000 annual observations: the correlation is still negative at around -15 per cent.
Although not shown in Figure 3, it could be argued that, over a long period of time, while the negative correlation between annual share return and annual inflation moderates, the relationship is not a positive one over any time period.
Hence, there is no observable positive correlation between share prices and inflation on average, and if anything, the correlation is negative.
Annual share return generally moves in the opposite direction to annual inflation.
Against all this risk that shares pose, relative to inflation, if instead inflation-linked bonds were used, a handsome 7.70 per cent was earned in average annual terms since 1951 in the United States with a zero risk to inflation.
In contrast, while shares provided more return – around 11.25 per cent on average for the period 1951 to 2013 – they generated that return with a whopping 16.86 per cent annualised risk to inflation.
In other words, you get more return from shares, yet the return comes with a massive risk to the main driver of retirement expenses: the rate of inflation.
Conclusion
Sometimes myths help us achieve objectives which might be more difficult in the absence of that myth. For example, many political philosophers over the years have argued that political association is made possible by what is referred to as the “noble lie”.
Yet, when an investor’s retirement spending is on the line, the need to be careful and to avoid myth-making is paramount, especially in the current environment of “fear and loathing” in Washington.
We argue that the current impact of political wrangling is only just becoming apparent in terms of the economy, as seen in recent readings of the Economic Surprise Index.
Much more is to come.
If you think that rationality will prevail, in terms of the forthcoming negotiations in Washington, then we would strongly urge you to think again.
What will happen in early 2014 will set the scene for the November 2014 mid-term elections – and we can imagine that, at best, another delay of agreement on the debt ceiling will occur.
This means that shares face an ongoing problem; economic growth will be hampered by continuing political risk, and the idea that investors can obtain a hedge against inflation by using shares will need to be thoroughly re-examined.
We argue that those relying on shares for retirement spending, on the premise that annual share return is positively correlated to the annual Consumer Price Index, are living in hope.
This is why, in such an environment, the use of inflation-linked bonds, at around a yield of 4 per cent over inflation, makes a lot of sense.
Some possible ILBs (inflation-indexed bonds) to consider, which assist with inflation hedging at generous real yield levels (shown at inflation plus), are as follows:
- Jem New South Wales Schools 2035 at 3.70 per cent – $10K min
- Electranet 2015 at 2.30 per cent – $50K min
- Australian National University 2029 at 3.25 per cent – $10K min
- Sydney Airport 2020 at 3.90 per cent – $10K min
- Sydney Airport 2030 at 4.50 per cent – $10K min
- Queensland Treasury Corporation 2030 at 2.62 per cent – $20K min.
Note: All of the bonds are available to retail investors. Minimum amounts vary as shown, but there is a minimum initial investment of $50,000. Rates shown are accurate as at 30 October 2013 and subject to change.
Dr Stephen Nash is director, strategy and market development at FIIG.
