Does Inflation Hurt Stock Returns?

Below is an excerpt from our latest WJ Notes newsletter. The full piece examines how inflation affects stocks, bonds and alternatives as well as our own positioning in those asset classes. 

Stocks

Stocks are always more complicated to predict than bonds. There are several factors to consider when predicting how they will perform during a period of inflation.

What were the valuations going into inflation? How will higher interest rates affect corporations ability to take on debt? Could some of the companies that exist today survive if they had to pay twice as much in interest? What types of industries could effectively raise their prices to keep up with inflation?

For example, the United States’ most famous inflationary period is the 1970s. Below is how different industry’s stocks performed during that decade.

As you can see, Energy was clearly the standout in this decade (which makes sense given the oil embargo) while healthcare lagged the most.

One of the issues with looking at history for inflation guidance is there are not many periods to reference, and many of the conclusions may not be relevant to today’s market. For example, you may have noticed the table above does not have a “tech” industry, because it did not exist back then. Today, tech is by far the largest sector in the market. Energy, conversely, is one of the smallest.

A better way to analyze stocks may be to just lump them into two baskets, value and growth stocks. Value stocks tend to be lower priced stocks in less flashy names and industries (energy, financials, utilities, etc), while growth has higher valuations in faster growing industries (tech, healthcare, consumer discretionary, etc).

The table below shows the annual returns of value over growth, by decade. You will notice that the best decades for value were in the periods with the highest inflation, and by a large margin.

To recap, although stocks managed to eke out a small real return in the high inflation years of the 1970s, they were obviously impacted negatively. The table below shows stock returns over inflation by decade. Aside from the 2000s (which had two recessions) the inflationary years were by far the worst for stocks.

Of course, not all stocks are created equal. There are certain industries that can better pass on the costs of inflation to its customers. A high-quality business with low amounts of debt or high profit margins should be able to ride out some rough years longer than a low-quality business. Being able to target these kinds of stocks from the rest is critical in riding out high inflation.