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The Advantage for Stocks When Inflation Rises

How stock and bond prices work when inflation is an ongoing possibility.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

This column is inspired by an article published by a reader. (Most seem to have accomplished more than I have.) In “How Inflation Altered the Stock-Bond Relationship,” Lawrence Hamtil writes that, relative to stock prices, bond yields have become higher in recent decades,because of uncertainty about inflation.

The logic is straightforward. Inflation does not affect the payments made by conventional (as opposed to inflation-adjusted) bonds. Whether consumer prices are flat or grow by 10%, a Treasury note with a 4% coupon will pay $40 for every $1,000 of par value. Its distribution never changes. But inflation does influence corporate earnings. Because businesses can raise their prices in response to inflation, at least partially, they offer at least some protection against that danger.

Until the early 1970s, writes Hamtil, this feature went unappreciated because inflation was not a serious concern. Prices briefly surged after World War II, and then again during the Korean War, but investors correctly viewed those spikes as temporary. When supply caught up with demand, inflation subsided. However, after President Nixon cut the nation’s final ties with the gold standard by suspending the Bretton Woods system in 1971, the genie was released. High inflation became an ongoing possibility, thereby reducing bonds’ attractiveness.

Hamtil concludes by noting that equities need not be perfect inflation hedges to outdo bonds. They merely need to do something. True that. Which leads to the next issue: To what extent have companies been able to overcome inflation?

The 67% Rule

The question cannot be precisely answered because the sample size is small and the results vary. For example, when inflation skyrocketed from 1946 through 1948, so did real corporate earnings. But when inflation was equally high in the early 1980s, the opposite occurred. Adding to the difficulty of connecting inflation’s causes and effects is that higher prices sometimes immediately hurt real corporate earnings, while at other times their consequences arrive later.

Those caveats being noted, the following chart provides a reasonably accurate picture of the relationship between real corporate earnings and inflation. It shows the average annualized rate of 1) real earnings growth and 2) inflation for companies in the S&P 500, over each decade from the 1950s through the 2010s.

Real Earnings Growth and Inflation, by Decade

(Annualized real S&P 500 earnings growth and inflation %)
A bar graph showing, from the 1950s to 2010s, the annualized real growth in earnings for the S&P 500 and the annualized U.S. inflation rate, by decade.

The very lowest decade for inflation, the 2010s, also registered the strongest real earnings growth. As that evidence suggests, companies can benefit from predictably low inflation rates. However, inflation was almost as tame during both the 1950s and early 2000s, in the first case with average corporate-earnings growth and in the second with poor results, thanks to the double-whammy of the technology-stock meltdown and the global financial crisis.

Meanwhile, despite its rotten reputation, the “stagflation” decade of the 1970s wasn’t all that bad for corporate earnings. At 3%, annual after-inflation earnings growth placed fourth among the seven decades. That picture is somewhat deceptive, as it omits the earnings decline during the early 1980s, but the lesson remains. Corporations do indeed compensate for the damage of inflation by increasing the prices they charge their clients.

In short, companies can mostly overcome inflation’s tax, but not entirely. As a rough estimate, they can neutralize two thirds of inflation’s cost. The other third represents an opportunity cost, levied by macroeconomic disorder.

For Example

Let’s now consider how the differing levels of inflation insurance for stocks and bonds—partial for the former and none for the latter—affect their future payouts. The next chart measures how 1) the earnings yields (defined as earnings divided by price) for stocks and 2) the yields on bonds can be expected to behave over time, assuming typical economic conditions.

Specifically, the study assumes 2% annual real corporate earnings growth while modeling three levels of inflation: 1) none, 2) 2.5%, and 3) 5%. When inflation is dormant, the annual growth in equity earnings yield equals the real amount of 2%, while bond yields remain unchanged. However, when inflation exists, the nominal equity earnings yield receives a multiplicative bonus of (by this column’s estimate) two thirds of the inflation rate. The net effect is that nominal earnings on stocks increase by 3.7% per year in the second scenario and by 5.4% in the third.

The year 1 figures represent current financial market prices: an earnings yield of 4.1% for the S&P 500 and (as of this past Friday) a 10-year Treasury note yield of 4.2%. The illustration then depicts how those yields would change over the next 10 years, using the above assumptions.

Earnings Yields Versus 10-Year Treasury Payouts

(Assuming 2% real earnings growth and three inflation rates)
A line chart showing the earnings yields for U.S. stocks and the yield on 10-year Treasury notes, assuming 2% real earnings growth for stocks, current yields on the S&P 500 and 10-year Treasuries, and three different inflation regimes: 1) annual inflation of 0%, 2) of 2.5%, and 3) of 5%.

Note how much more attractive equities become, relative to bonds, as inflation rises. When inflation is absent, the equity earnings yield only gradually surpasses the 10-year Treasury yield, reaching 4.9% when the decade ends, as opposed to the bond’s steady 4.2% payout. But when inflation surfaces, the equity earnings yield increases to 5.7% for the medium-inflation case. If inflation is high, the final earnings yield is a generous 6.6%.

True, rising inflation can harm stock prices by reducing the multiple that investors will pay for a given amount of earnings. That occurred during the 1970s and early 1980s, as declining price/earnings ratios lowered stock returns. During that time, however, long bonds performed even worse.


This article’s numbers are merely illustrative. The 67% estimate for equities’ level of inflation protection was derived—roughly—by summarizing several decades’ worth of evidence. In any single period, the percentage of inflation that corporations can absorb without suffering a decline in real earnings will vary. However, the model does demonstrate how the underlying math works. Bond investors must wish fervently against the resumption of inflation. Equity shareholders need also care—but nowhere near so deeply.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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About the Author

John Rekenthaler

Vice President, Research
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John Rekenthaler is vice president, research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

Rekenthaler joined Morningstar in 1988 and has served in several capacities. He has overseen Morningstar's research methodologies, led thought leadership initiatives such as the Global Investor Experience report that assesses the experiences of mutual fund investors globally, and been involved in a variety of new development efforts. He currently writes regular columns for and Morningstar magazine.

Rekenthaler previously served as president of Morningstar Associates, LLC, a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. During his tenure, he has also led the company’s retirement advice business, building it from a start-up operation to one of the largest independent advice and guidance providers in the retirement industry.

Before his role at Morningstar Associates, he was the firm's director of research, where he helped to develop Morningstar's quantitative methodologies, such as the Morningstar Rating for funds, the Morningstar Style Box, and industry sector classifications. He also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

Rekenthaler holds a bachelor's degree in English from the University of Pennsylvania and a Master of Business Administration from the University of Chicago Booth School of Business, from which he graduated with high honors as a Wallman Scholar.

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