Why is the equity return negative when inflation is above expectations?

CFA Level III Economics
#1

Why is the equity return negative when inflation is above expectations? I thought equity is a good instrument to hedge inflation. Any thoughts on this?

Thank you!

#2

Well, the return would be less than expected but I wouldn’t say it’s negative. And mots equities are better as long term inflation hedges. Not short. Most firms can’t just increase prices on demand whenever they want.

#3

High inflation may jeopardize a Company’s earnings. Depends on how successfully particular company can build in higher inflation into its product margin and pass through to customers. For goods which demand is high and company is on market without many competitors it may be possible otherwise not.

I agree with Googs. Equity is an inflation hedge but rather in the longer period. For shorter period REs or (some) commodities are better inflation hedge.

#4

I think the key to this questions is above expectations. In other words, there is going to be a level of unexpected inflation. This means that companies are not pricing their goods/services in order to account for it, and by the time the higher inflation materializes their costs will likely increase. Many of the companies will then struggle to pass down the cost and the likely result will be margin compression which is a component of the return on equity.

This is also related to why central banks create expectation with regards to the level of inflation rate that can be expected in the economy. It is because bouts of unexpected inflation can have negative consequences, and at times even cause recessions.

As some mentioned it above, earnings growth has a nominal component (meaning that it has inflation rate built into it) so over long horizons of normal inflation rate it tends to provide a hedge.

#5

^He’ll pass.

#guaranteed

#6

Thanks for all the answers!! Totally forgot the short term vs long term and expected vs unexpected pieces.

I am having three day break due to a interview case study on mutual funds. Really hate to do this since I have not taken any break yet since I started to study…

But the case has a chart showing which asset is doing well in different environment with the Sharpe ratio. They mentioned in recession, stock has negative Sharpe, regular inflationary growth, almost 0 Sharpe but in Non-inflationary growth, it has positive Sharpe ratio. And that reminded me I just asked this similar question here :slight_smile: