Risk, cash and Inflation

Since 2008, we have lived through what might best be described as an ‘easy money’ era.

After the global financial crisis of 2008, keeping interest rates near zero served to ease financial pressure on governments, banks and households alike. It also had the effect of supporting asset prices.

What followed was a golden period for asset owners, who could borrow more cheaply and earn higher returns on risk assets. The benign liquidity environment made investing look easy – all risk assets, across asset classes, and also highly speculative ones, delivered returns.

The current period of inflation

However, since October 2020, a combination of factors has brought about some significant changes to the inflationary regime. These include:

• the rapid economic restart as pandemic-related restrictions eased, prompting severe disruption to supply chains.
• post-pandemic pent-up demand pushing up global energy prices; and
• geopolitical tensions inflamed by the Russia/Ukraine conflict and related sanctions affecting the supply of energy and key commodities.

The combined effect of the above has led to widespread supply-side price inflation across energy, raw materials and manufacturing costs.

The importance of staying invested

The current slew of negative political and economic news understandably impacts risk appetite for investors and managers alike. However, staying the course while adapting to the context is important. There are three reasons why:

1. Time in the market, not timing the market, delivers returns.
2. Compounded long-term returns tend to outweigh the losses prompted by episodic crises.
3. In the context of high inflation, cash is riskier than equities for capital preservation.

Trying to time the market to buy before ‘good’ days and sell before ‘bad’ ones is impossible. Staying invested is critical to capture all the good days that drive returns, but inevitably that means accepting some bad ones too. While it can be uncomfortable, it is better to stay invested.

And while it is never comforting to see negative returns as investors have done recently, it is important to put things in perspective. If we look at stock market returns since December 2007 – thereby capturing the financial crisis, the Eurozone crisis, the taper tantrum, Brexit, Covid and war – both cumulative and annualised returns remain strong.

Investment risk vs inflation risk

It is important to consider ‘risk’ in a broad sense: not just investment risk, but inflation risk too, in the context of time. The difference is outlined below:

Relationship between risk and time during a higher inflation regime

	Short-term	Long-term
Cash	Lower risk	Higher risk
Equities	Higher risk	Lower risk

 

 

 

 

 

Source: Elston research, for illustration only

Investment risk, often measured in volatility, is the flip side of returns. So in a benign market environment, when things are going well, volatility is your friend – you receive a reward for the risk taken. But in a malign market environment, when things are getting difficult, volatility is your foe – you receive a negative return for the risk taken.

This is why your adviser should always discuss the impact of volatility with you.

Higher risk assets such as equities may appear volatile and will fluctuate. However, in an inflationary regime, they are safer than cash over the medium to long term.

By the same token, lower risk assets such as cash may appear safe and not fluctuate, but in an inflationary regime cash is high-risk over the medium to long term as its purchasing power is destroyed by inflation.

The volatility of cash is not, in fact, zero, but is impacted by the volatility of inflation. And when inflation volatility is high, the riskiness of cash is high. In this respect, understanding the difference between investment risk (volatility) and inflation risk (loss of purchasing power) over time is key.

Equities vs cash in an inflationary regime

By way of illustration, we can look at the relative performance of equities (we use S&P 500 in GBP terms as a proxy) and cash during the period of high inflation in the UK from December 1972.

Over five years, an allocation to equities delivered a price return of -1.3 per cent (-0.3 per cent annualised) while cash lost -54 per cent of its purchasing power (14.2 per cent average annualised inflation).

Over 10 years, an allocation to equities gave a price return of +72.9 per cent (+5.6 per cent annualised) while cash lost -73 per cent of its purchasing power (12.4 per cent average annualised inflation).

And over 20 years, an allocation to equities delivered a price return of +473.7 per cent (+9.1 per cent annualised) while cash lost -84 per cent of its purchasing power (8.8 per cent average annualised inflation).

What we see is that staying invested and allocating to equities for the short, medium and long term in an inflationary regime can deliver preservation of purchasing power and capital growth.

Understanding the concept of equity duration

What do we mean by equity duration? In technical terms, the duration of an equity is the sensitivity of the price of that equity to any change in interest rates.

More practically, equity duration can be defined as the number of years it takes for an investor to recoup the price paid for a share from cash flows generated by that same share, that is, dividends.

The concept is useful when it comes to visualising the shape of future earnings of a particular share and its corresponding sensitivity to changes in interest rates in order to value those earnings in today’s money. And that is a particularly useful analytical tool in an inflationary regime when purchasing power and the value of money become more dynamic.

A conceptual measure

Essentially, it is the same calculation as that which is used for bond duration, but instead of measuring a stream of fixed interest payments, you are measuring a stream of earnings or dividend payments and therefore it is a conceptual tool rather than a definitive one.

There is no published equity duration figure for a particular equity because it depends on the analytical view of a company’s earnings profile and dividend policy.

Duration length and its implications

Equities that derive the greater proportion of market value from near-term income and forecast dividends (discounted back into today’s terms) have what would be described as short duration.

Equities that derive the greater proportion of market value from long-term income and potential dividends (discounted back into today’s terms) have what would be described as long duration.

As inflation and/or interest rates rise, discount rates increase and the net present value of an asset falls. And all things being equal, that fall is greater for long-duration equities than it is for short-duration equities.

So what kind of equities fare well during an inflationary regime from factor and sector perspectives?

How duration corresponds with factors and investment styles

Equities that are shorter duration and therefore have high near and medium-term income and forecast dividends – that is, the big, typically un-glamourous companies that generate steady income and regular cash flows – these tend to be value-style companies.

Equities that are longer duration and therefore have higher long-term earnings and potential dividends – ie a fast-growing business in a capital-intensive phase – these tend to be growth-style companies.

Companies with a value and/or income bias are expected to fare better in an inflationary regime and this theory has been supported by the data.

Companies with a value or income bias have relatively outperformed funds with a growth bias during the recent inflation spike in 2022. This trend may continue as the value rotation has further room to run.

You need real earnings to pay dividends. If a company is generating 10p per share of real earnings, it will more than likely keep pace with inflation.

This is because when interest rates go up (as they do in an inflationary regime), the value of those near-term payments is greater than the discounted value of potential growth and income that may be generated far into the future.

What does this mean for factors when inflation and interest rates are high?

The concept of investment factors was developed by the economists Eugena Fama and Kenneth French as they looked at drivers of investment returns beyond their capital asset pricing model.

They looked at the impact of size as a factor that is, market capitalisation, and also the impact of price to book value. Companies with low price to book value are value factor and those with high price to book value are growth factor.

When BlackRock analysed US equity market returns from 1927 to 2020, the results clearly illustrated that value has outperformed in all inflationary environments, particularly high-inflation environments.

Equally MSCI research on world equity data between 1994 and 2021 showed that value outpaced other factors whenever interest rates were rising.

In both instances, it is the shorter duration of value-style equities and their less-stretched valuations that underpin this performance.

Which sectors are investors tending towards in the current inflationary environment?

With inflation elevated and potentially persistent, investors have been rotating away from technology into traditionally boring sectors like consumer staples, materials and energy that benefit from rising prices or can pass on inflation.

The consequences of the most recent inflation spike has been binary; as commodity prices spiral upwards, this benefits businesses in the energy and materials sectors, and penalises manufacturers in the consumer discretionary sector, for example.

As the cost of living squeeze has an ever greater impact on populations worldwide, non-essential spending is weakening considerably, further undermining consumer discretionary businesses.

The frothier end of the technology sector has also suffered a significant de-rating as investors increasingly focus on dependable businesses with reasonable valuations, a reliable growth trajectory and real-time profitability.

As humans we are asymmetrically loss averse – a lost £1 gives more pain than a gained £1 gives pleasure – but in an inflationary environment it is important that investors are not paralysed by risk aversion.

Performance since the 1970s illustrates the equity market’s value as a long-term protector of returns. Investors just need to ensure that they allocate to the factors and sectors that will afford optimum preservation.

This article by Henry Cobbe (Head of research at Elston Consulting) first appeared on ftadviser.com