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:

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:

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:

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:

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:

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. [↩]

UK REITs and Property Authorised Investment Funds (PAIFs) pay a special kind of dividend known as Property Income Distribution (PIDs).

The UK tax system treats PIDs as property letting income. Consequently they are taxed at higher rates than ordinary dividend income.

Just to complicate matters further, REITs and PAIFs may pay a combination of PIDs and ordinary dividends.

The fund should make it clear how much you receive of each type on your dividend voucher.

As with ordinary dividends, the tax you’ll pay on your PID income depends on:

• Whether you receive the income within a tax shelter (an ISA or a pension)
• Your personal income tax rate

As always buying your property investments within a tax shelter is the way to go if you have the spare capacity for them.

Note: Specialist property index trackers (such as the iShares ETF with the ticker IUKP) funds pay ordinary dividends not PIDs. That’s because they are not UK REITs or PAIFs. They may receive PIDs from UK REITs that they hold. But by the time the income reaches you as a shareholder in the tracker fund it’s a dividend.

Property Income Distributions within a tax shelter

You do not pay tax on PIDs held within tax-sheltered accounts.

However, unlike ordinary dividends that are paid gross (that is with no tax deducted), PIDs are generally paid with 20% tax deducted.

This means that the tax already paid needs to be clawed back.

Your tax-sheltered account should be issued with a 20% tax credit associated with your PID income.

The broker that runs your ISA or pension should use this to reclaim the tax paid from the taxman.

Notice we said “should”.

Twice!

Keep your eyes peeled to ensure your PID tax is being reclaimed by your broker. Sometimes they forget.

It can take four to six weeks after the PID is credited to your account for the reclaimed tax to turn up as cash.

PIDs outside of tax shelters

Are you holding your PAIF and receiving your PIDs outside of a shelter?

Sounds painful!

And tax-wise it is, compared to if you’d held it within an ISA or a SIPP.

You’ll need to work out what tax is due on your PIDs and other share income when you submit your annual self-assessment tax return. (Avoiding all the resultant tedious paperwork is reason enough to justify an ISA.)

The first thing to know is that PIDs do not benefit from the tax-free dividend allowance.

Most UK taxpayers must pay the standard rates of income tax on PIDs:

• 20% – basic rate 
• 40% – higher rate
• 45% – additional rate

(Rates can vary if you’re a Scottish or Welsh taxpayer.)

You should receive your PIDs with a 20% withholding tax already deducted.

• Basic-rate taxpayers have nothing further to pay
• UK higher-rate payers owe HMRC another 20% of the gross amount
• Additional rate payers must cough up 25%

If the 20% deduction means you’ve overpaid tax then you can claim it back from HMRC.

This may apply for instance if your PID income falls within your personal allowance, or within a sub-20% income tax band.

Do not record your PIDs on your tax return as ordinary dividends. HMRC’s tax return notes offer further guidance.

Incidentally, non-resident shareholders may be able to claim back some of the withholding tax that’s pre-paid on UK REITs.

That’s possible if you live in a country that enables you to claim back a portion of withholding tax on UK securities. See this explainer from HMRC.

What caught my eye this week.

Last week we talked about the infamously inverted yield curve in the US. Meanwhile here in the UK the Bank of England has already hiked its policy rate to 0.75%. Now policymakers and pundits alike are mulling over how much faster and farther central banks will go.

There are various ways a higher Bank Rate could slow (or worse) the economy. Theories will lead you into a Spaghetti Junction of the money supply –  M1, M2, M3 and beyond – or down other half-forgotten cul de sacs.

In the UK though, it’s probably easiest just to think about the housing market.

For good or ill (okay, ill) the UK economy is still geared around property and especially residential homes. A sector that seemingly has been flying through the stratosphere on fumes for decades.

But I believe when something has been seemingly running on fumes for decades, it’s probably better to assume you haven’t properly identified the fuel.

In the early 2000s both politicians and punters blamed supply and demand for high house prices. And I did too, for what it’s worth. Not enough houses were being built to meet demand, we believed. Never mind that rents had failed to soar by anything like the same extent – even though everyone has to live somewhere.

About a decade ago I finally realized that interest rates were all-important. Along with the laxity of bank lending, rates decide how much somebody feels they can pay each month for a property.

Very many home buyers will pay as much as they can manage without totally derailing their lifestyle. They hope prices will rise in time, or if not that their income will. And most pay via a mortgage.

What could go wrong?

Something going up beyond the rent

Take a look at this graph from Capital Economics, as highlighted this week by This Is Money:

The graph suggests that soon mortgage payments will become more expensive than rent. This should not normally be the case, because landlords want to make a profit1.

As rates and house prices rise, the monthly payments required to own a home via a mortgage climbs further. The graph forecasts that monthly payments will soon be above their last peak.

Of course, a pound is worth a lot less now, and it will be worth even less by Christmas. But the pressure from rates shrugging off their torpor and struggling to their feet is clear.

Caveats abound. Many people are on fixed-rate mortgages nowadays. Affordability is stress-tested when you get a mortgage. The nice lads on The Property Podcast reckon this cycle has several years more to run as regulations are loosened and banks go a bit crazy.

Also, would policymakers really want to provoke a housing market crash by raising rates too far?

Long ago I used to scoff at such talk as clutching at straws in the face of an elevated market. But actually, presuming policymakers will do all they can to avoid a repeat of the early 1990s housing crash has been a pretty good heuristic over the years. How much higher could Bank Rate go before roiling UK PLC and its stretched populace?

With vast government debt also looming large, you can see the appeal of inflating away these problems by avoiding real yields from climbing too far (aka financial repression).

In such a world, you might think you’re getting finally 4% from your savings account, but you’re forgetting inflation is running at, say, 5%. The real value of your money is still getting gently mullered.

Interesting times. Have a great weekend all!

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1. Although that’s yet another truism that’s gotten screwy in the near-zero interest rate years, as landlords in pricey parts of the country have banked on capital returns. [↩]