How inflation swindles the equity investor

Equities have traditionally been considered a good hedge against inflation. This may not be the reality, writes Joe Roseman.

It is human nature to go into denial when faced only with unpalatable options. Regrettably, there are seemingly no palatable options to the fiscal hangover that has infected the OECD economies.

Yet, having said that, a new NBER working paper by Professor Carmen Reinhart shows governments have been in this position before, and there does appear to be a default mode. No pun intended.

What history tells us

According to Reinhart, history shows that time and time again, when faced with a massive debt overhang, governments elect to impose what Reinhart calls “financial repression”. Effectively, Reinhart argues that by maintaining a prolonged period of negative real interest rates, governments reduce their stock of debt in relation to GDP by (effectively) transferring wealth from savers.

And, as Reinhart elaborates, this process is politically attractive. “Unlike income, consumption of sales tax, the repression tax rates are determined by financial regulations and inflation performance that are opaque to the highly politicised realm of fiscal measures.

Given that deficit reduction usually involves highly unpopular expenditure reductions and (or) tax increases of one form or another, the relatively “stealthier” financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts.”

Reinhart shows that between 1945 and 1980, UK real yields were negative about 50% of the time. If the study had looked at T-bill rates, it would have shown negative real yields 60% of the time. According to Reinhart, maintaining a prolonged period of negative real yields allowed the UK government to reduce its debt burden by around 3%-4% per annum on average.

It makes intuitive sense that governments across the OECD will err towards the Reinhart model for addressing their respective fiscal woes. It will be ‘stealth theft’ on an industrial scale. So far, we are only into year two of negative real interest rates. As investors, we have to ask the question of what persistently negative real yields will do for a portfolio.

Number crunching

Fortunately, the Barclays Equity Gilt study has already crunched the historical performance numbers. If one had invested £100 in gilts at the beginning of Reinhart’s financial repression era in 1945, then by 1980 that £100 had turned into £32 after taking inflation into account. If one had placed the money into T-bills, the £100 would have turned into £70. Equities, on the other hand, saw the £100 return £448 by 1980 after inflation had been factored in.

So, it seems, equities provide that crucial protection against the ravages of inflation over time. It is certainly true that I have heard this thesis promoted by more experts than I care to mention. It is accepted wisdom. In a recent meeting, I challenged the notion in a public forum. I was looked at like the village idiot.