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Inflation and stock market performance – when high inflation hurts

Until recently as culturally relevant as Beanie Babies and as potent as a celery lightsaber, inflation fears are back in the news. But what about inflation and stock market performance? Is it true that equities can always shrug off inflationary environments, while elsewhere in our portfolios bonds sink like a concrete bathing costume?

As investors, that’s obviously the million dollar question for all of us.

[Office boy runs into The Accumulator’s cell at Monevator Towers and hands him the latest inflation print, fresh off the anachronistic press.]

Okay, make that the one million and eighty-thousand dollar question.

Note: All investment returns quoted in this article are annualised real returns.1

Inflation made in the UK

Britain has suffered repeated bouts of high inflation throughout its history. You can see the spikes in vivid red in this graph from Economics Help:

A graph of UK inflation from 1860 to 2015.

The worst high inflation shock occurred during World War One. The annual rate of inflation peaked at over 25% in 1917.

The 1970s were similarly grim. Inflation rose to 24.2% in 1975.

Double-digit inflation died away in the 1980s and the monster has been mostly tame since. Until now. (Though there was a 9.5% mini-rampage in 1990, and some brief snarls in 2008 and 2011.) 

Inflation and stock market performance: the good, the bad, and the hideous

How did UK equities (and bonds) fare during bouts of high inflation? Behold the horrible history:

A graph showing how UK equities and government bonds perform against inflation.

Source: Sarasin & Partners. Compendium Of Investment 2022. Page 46. 

  • UK equity returns averaged -7% when mean inflation broached 15%. (See the left-hand side of the graph.) The good news is otherwise equities maintained positive growth in the face of inflation. 
  • UK government bonds were slaughtered at an annualised rate of -14% when inflation was very high.2

This pattern is repeated across 21 developed world markets in this chart:

A graph showing how developed market equities and bonds have fared during different inflationary regimes from 1900 to 1921.

Source: Elroy Dimson, Paul Marsh, and Mike Staunton.
Credit Suisse Global Investment Returns Yearbook. 2022. Page 13. 

The inflation numbers dot the dark turquoise line. We can see that equities and bonds suffered devastating real returns of -10% and -25% respectively when inflation averaged 18% or higher – that’s the column on the far-right.3 

However when inflation ‘only’ averages 7.4% or higher, equities eke out a small positive return. 

The two graphs above also reveal that rising inflation is correlated with lower equity returns – even when it doesn’t plunge them into negative territory. 

The relationship between inflation and stock market performance isn’t always so clear cut though. Equity returns can be stellar in a high inflation environment. 

UK equities grew over 32% in 1977 when inflation was 15.8%. And they delivered over 17% in 1980 when inflation was 18%.

Crucially, inflation wasn’t as bad as expected in either year. The market had already priced in high inflation. Equities then surged as investors responded to encouraging news.

Unexpected inflation is the real threat

‘Unexpected inflation’ describes rising inflation rates that are worse than expected. 

Definitions differ. But when inflation rises sharply from one period to the next, equity and bond investors should brace for impact. 

The next chart shows MSCI World equities losing nearly 2% a month in the worst 25% episodes of higher unexpected inflation:

A graph showing that equities and bonds suffer when unexpected inflation is at its worst

Source: Anjun Zhou, and Karsten Jeske4. Unexpected Inflation Hedging 2012. Page 5. 

And now a chart that shows the same lookup, only this time we see a rosier relationship between expected inflation and the stock market.

Notice that equities and even bonds ride out the worst episodes. That’s because high inflation was already in the price:

A graph showing that equity and bond returns remain positive when inflation is expected

Short-term inflation isn’t likely to spook the markets, either. Disruptions that are quickly overcome – such as a tanker running aground, or an attack on a pipeline – do little harm to the long-term outlook.

No, the unexpected inflation environment we should fear is: high, rising, and long-term. 

How to beat high inflation

One way to beat high inflation is to invest in asset classes that outstrip inflation over time. 

Global equities’ reputation for being an inflation-beating investment rests on the asset class’s historical real return average of better than 5%. That’s comfortably ahead of long-term inflation.

Equities do suffer during bouts of high, unexpected inflation. But you can be relatively sanguine they’ll come out ahead eventually. 

The key word is ‘eventually’. The UK’s worst stock market crash smashed equities between 1972 and 1974 as inflation ran riot. It took until 1983 for investors to break even.

In contrast, inflation-hedging is a different strategy. With hedging, we’re looking for assets that deliver high returns when inflation runs riot. 

We’ll go hunting for those in the next post.

Take it steady,

The Accumulator

  1. Annualised is the average annual return accounting for gains and losses. Real return is the amount the investment grows (or shrinks) over a period after inflation is stripped out. []
  2. The data sources use long-bond returns. Long bonds fare much worse than shorter duration bonds against inflation. []
  3. Note: This data contains some instances of extremely high post-war inflation. []
  4. That’s Karsten of Early Retirement Now fame. []
{ 8 comments… add one }
  • 1 tom_grlla April 13, 2022, 7:42 pm

    I’m quite fascinated by the Horizon Kinetics ‘Inflation Beneficiaries’ ETF (Actively managed, I hasten to add). It aims to invest in companies that will do well whether there is inflation or not (in contrast to a hedge) which is obviously quite appealing.

    However it doesn’t seem to have UK Reporting Fund status (last I looked a few months ago) as they’re a US house. If anyone has any contacts there… please put a word in!

  • 2 ADT April 14, 2022, 9:18 am

    Seems like there has been a prediction of inflation since even before the pandemic, maybe since all the financial crisis QE, so is the current inflation spike “expected”?
    If so, I guess there’s nothing to worry about…

  • 3 flotron April 15, 2022, 11:20 am

    Not relevant to the article, but pages on this site after the sign off – “The Accumulator”, (not including footers) are now all appearing in italics which looks odd.

    Or is it just me? (same in Chrome and Firefox)

  • 4 The Investor April 15, 2022, 11:20 am

    @flotron — Thanks for the head-up, it’s not just you. Having an investigate now!

  • 5 PeterW April 16, 2022, 4:28 pm

    Does the source on unexpected vs expected inflation effects say how far ahead inflation needs to be forecast for it to be called “expected”? I couldn’t see an explanation in a quick look.

  • 6 The Accumulator April 16, 2022, 7:05 pm

    @ PeterW – The Unexpected Inflation Hedging paper compares actual inflation vs 12-month prior inflation forecasts. One of the data sources they use for the forecasts is the Survey of Professional Forecasters.

    Wikipedia says: “The Survey of Professional Forecasters (SPF) is a quarterly survey of macroeconomic forecasts for the economy of the United States issued by the Federal Reserve Bank of Philadelphia.”

    I can see various inflation forecasts out there for the UK from the OBR, Bank of England, OECD, and various private institutions.

    @ ADT – My personal feeling is that the sources I’m reading are typically suggesting that inflation is running ahead of expectations. Even a few months ago many commentators thought high inflation would be temporary. They seem much less certain now.

  • 7 PeterW April 17, 2022, 7:33 am

    @The Accumulator – thanks!

  • 8 Nomadic Samuel May 1, 2022, 1:22 am

    Wow! That graph. Playing around with Portfolio Visualizer really opened my eyes to inflation. Also traveling to countries like Argentina where restaurant menu prices had stickers.

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