Are Stocks a Good Hedge Against Inflation?

On this episode of The Long View, Jeremy Schwartz, the global chief investment officer for WisdomTree Investments, discusses the market outlook, stocks, inflation, and ‘do-nothing’ strategies.

Here are a few excerpts from Schwartz’s conversation with Morningstar’s Christine Benz and Jeff Ptak.

Stocks for the Long Run

Benz: You’ve referenced several times the research that you’ve done with Jeremy Siegel and Stocks for the Long Run. Can you talk about inflation and the relationship between stocks and inflation? Your research does point to stocks being probably the best inflation hedge that money can buy. For those who might not be familiar with the research, can you talk about what has made them so good at offsetting inflation?

Schwartz: And you see that this year with all the inflation that’s in the system, you tend to see companies raising prices. So, they’re passing along price increases. They’re even sacrificing volume. One of my friends is using the term “price over volume.” You see it in a lot of the earnings reports that companies are pushing price and even sacrificing volume. And that goes to, over time, companies are really good long-term inflation hedges. And as you say, in the book we show that long-term real return to stocks, that real return is after inflation. That 6.7% we quoted very early on when we talked about capital market expectations, 6.7% was the return above inflation. So, if you go back in Siegel’s 200 years of data, the first 130 years, there was basically no inflation. And then, you’ve had 70, 80 years of inflation. And over the 200 years, inflation has been down about 1%, but over the last 80 years, there’s been inflation about 3%. And what you find is that the real return to stocks was basically over the very long periods the same with inflation as when there was no inflation. So, you didn’t see your real return go down at all with the inflation that we’ve experienced.

Bonds, by contrast, historically didn’t have any inflation-adjusted bonds. The real risk to bonds was that there’d be higher inflation and that the coupons wouldn’t offset that. But in the short run, when the Fed starts battling inflation and hiking rates like it did last year—last year was a bad year for both stocks and bonds, the first bad year for stocks and bonds in a very long time. In the short run, as the Fed starts fighting, it can be painful for stocks. But over the long run, as you see companies pass along price increases—they’re what we call real assets—they tend to grow earnings and dividends along with inflation. If you go back to the original S&P study that we started the interview with, the S&P’s dividend growth since 1957 has been about 2.0% on top of the 3.7% inflation. So, you get real growth on top of the inflation hedging that you get with the fundamentals offsetting that. And so, that’s part of why we view stocks as the best long-term inflation hedge.

Why Are Stocks Good Inflation Hedges?

Ptak: When you did your research, I would imagine one of the things that you did was try to decompose what made stocks the good inflation hedges they were. And I suppose there’d be a few sources. One is dividends. The other two ostensibly would be multiples. You could get some multiple expansion and then also earnings growth, whereby there would be some pass-through of the price increase, and they would be able to deliver higher earnings as a result, and it would somewhat offset the price pressure.

So, when you try to decompose it, what did you find? Was it the case that maybe the market sniffs out inflation ahead of time, they sell off stocks, the multiples get nice and low, and you get multiple expansion in the years since and that helps you to hedge some of the inflation? Or was it a combination of that and maybe their ability to pass price increases along?

Schwartz: I think each period is going to have—the short-term time periods definitely—more of the volatility coming from valuation adjustments than underlying earnings growth. But over the real long run, it’s the earnings growth that drives the return. So, I think, if you go back that 50-plus years, most of the return was dividend yield plus dividend growth, not most of it was valuation. You could decompose it to probably roughly 3% average dividend yields, much higher in the first part and much lower in the second part. Now you’re closer to 1.5% on the S&P 500. But back in the ‘50s, ‘60s, ‘70s, you got above 3%, well above it. So, call it a 2.5% to 3.0% average dividend yield going back to the history of the S&P, and it was about 6% dividend growth. That’s roughly 8% to 9% of the returns coming from fundamentals, very small amounts from valuation over the long run.

You could say now you might think valuations need to compress. We’re not in that camp. We think valuations are fair and normal today at a little bit below 20 times. What we actually think the new equilibrium-type P/Es are warranted. But you could add or subtract the valuation change in the future over the long run. In the short run, all sorts of things can compress or expand on what’s happening in that environment. Right now, people are worried about earnings collapsing with the recession or the recession that never comes. But everybody is worried about the recession, what’s going to happen to earnings? I gave a view on what could support earnings on the dollar coming out later this year. And I think one of the reasons earnings haven’t gone down so much is the dollar being weak in the last six months. But those earnings risks are, in a recession, you should pay up for it. You shouldn’t apply depressed multiples at depressed levels of earnings. You could arguably justify a 22 P/E instead of a 16 P/E. But the bears out there today are saying, “Hey, it’s not going to be 200 on the S&P, it’s going to be 180, and then we’re going to apply a 16, 17, or even lower.” Whereas we think you should apply a higher multiple. So, that’s a little bit on the short-run versus long-run valuation question.

What Inflation Hedges Should Investors With a Shorter Time Horizon Consider?

Benz: Going back to the idea of stocks as an inflation hedge, I think that one of the issues consumers and investors wrestle with when it comes to inflation is that they don’t have a long enough time horizon to make stocks a suitable inflation hedge. This is especially true of retirees who are interested in preserving their purchasing power. What’s the next best inflation hedge that they should consider?

Schwartz: What you couldn’t do historically, and why bonds had a 30-year negative return, is that bonds didn’t have any built-in inflation hedges. And so, in that 30-year stretch where you had very high inflation and rising interest rates coming to the peak around 1980, you had this negative return for bonds. If you go back a year ago, you had negative inflation-adjusted bond yields, and people were locking in. They were giving the government $100 and taking $90 back after inflation, which was kind of crazy at the beginning of last year.

Yields have risen dramatically from the bottom. And you’re now about 1.5% on the 10-year TIPS bonds. So, if you really are afraid of inflation, you can get this 1.5% coupon plus the inflation adjustment. That is a much lower risk than traditional bonds in that sense. So, that’s probably the next best thing. There’s a cost to that. If you’re going to hold a stock for 10 years versus holding the TIPS bond for 10 years, I think you’re going to do well better in the stock—if you’re not looking at the price volatility day to day. Like you said, retirees might not have the stomach to hold the stock for 10 years without looking at it, and they want the bond with a lot less volatility. I think at 1.5%, it’s probably fair value. We talk a lot about how future bond returns are likely to be lower. The demographic trends, population trends and productivity combined give you a lower real economic growth. That means lower real interest rates. So, at 1.5%, it may be approaching good fair value on TIPS. I think that’s probably the next best.

If they did want a little bit more risk beyond that 1.5% coupon you’re getting in TIPS bonds, I do think energy stocks. Now they’re more volatile places of the market, but they are the cheapest sector in the market—10 times earnings. Energy is one of those places where inflation shows up. I think they’ve been acting as one of the few diversifiers to core S&P stocks. It’s certainly one of the biggest risks is that there’s more inflation causing, again, declines in stocks, declines in bonds. I do think that’s one of the sectors that offers an interesting play to hedge inflation also.