I’m an active academic and long-time finance professor, so I stay on top of the latest academic research in the fields of finance, especially investments. On occasion, I provide short, easy-to-read summaries of recent and relevant academic research, to help you give your clients the best and most cutting-edge investment advice.
Many of us expect inflation to continue to rise. This is no surprise, because, we have had very low inflation in recent years. A couple of years ago, it was around 0 percent and sometimes even negative, but inflation has been rising recently and right now inflation is already over 2 percent. However, one thing that investors commonly (and mistakenly) do when inflation rises is move out of equities and into other assets, such as money market securities and bonds. According to standard portfolio theory, however, inflation is not a factor that investors should consider when allocating between risky assets and non-risky assets. However, according to a new academic study that will appear in the Journal of Financial Markets, rising inflation leads to outflows from equities. The effect is dramatic. Here is a quote from the study:
“Our point estimates suggest that a one standard deviation increase in inflation is associated with a 0.45 percent decrease in the rate of equity mutual fund flows in the next quarter (deflated by the US GDP). In dollar terms, this decrease translates to roughly $27 billion fewer dollars flowing to equity funds.”
Why do investors do this? The study’s authors find support for the “inflation illusion” hypothesis. This is where investors increase discount rates, due to inflation, but they do not increase their estimates of the nominal growth rate of cash flows. Put another way, investors expect firms’ costs to rise due to inflation, but they forget that revenues will likely rise too due to inflation. As a result, investors mistakenly undervalue stocks when inflation rises, when in fact, the effect that inflation has on stocks should end up being a wash. Let’s do some Finance 101. Consider the basic formula for valuing a stock with constantly growing dividends, which is simply next period’s dividend divided by the difference between the stock’s required rate of return (given inflation and risk) and dividend growth rate. If next period’s dividends are $2 per share, and the required return is 6 percent and the growth rate is 2 percent, then the stock should be valued at $50 per share (i.e., 50=2/(0.06-0.02)). However, if inflation rises by 2 percent , then the required return rises from 6 percent to 8 percent, and the growth rate rises from 2 percent to 4 percent, then note that the stock is still valued at $50 per share. However, according to the study, it turns out that many investors forget to increase the nominal growth rate of cash flows, and so they may value the stock at $33.33 per share when inflation rises by 2 percent (i.e., 33.33=2(0.08/0.02). That is, investors expect inflation to rise and thus stock prices to fall, so they move out of equities. But, inflation should logically have no effect on stock prices, and so investors should not be moving out of equities.
What is the overall takeaway? If you have clients who are thinking about getting out of equities because of rising inflation, then you may wish to educate them that inflation should not have an effect on stock prices.