Implications of Inflation

Until the early 20th century, the money supply was primarily dictated by the supply of gold and silver backing up bank deposits. This made periods of both deflation and inflation expected. Now that fiat currencies are backed by the faith and credit of central governments only, inflation is the norm. The US Federal Reserve, for example, sets a target inflation rate of around 2%. Why 2% and not 0%? Because a 2% percent buffer keeps inflation from turning into deflation. Persistent deflation is damaging because it undermines the following:

• Debt finance investments: Future repayments are less valuable in today’s dollars.
• The power of the central bank: The Federal Reserve’s power to make changes is undermined when rates are near zero.

Moderate inflation is preferable to deflation; therefore, central banks are more willing to tolerate a little inflation to avoid deflation altogether. Inflation is procyclical, meaning it picks up steam in an expansion and cools off in an economic contraction.

Inflation Effects by Asset Classes

While the effects of inflation among varying asset classes can be somewhat distinctive, specific patterns emerge, leading investors to favor various asset classes in times of rising or falling inflation. It should also be noted that rising interest rates tend to be procyclical just as inflation does, meaning that they often rise and fall together. This will form the basis of the logic for the following paragraphs.

Inflation Effects on Cash

In this context, cash means short-term interest-bearing instruments, not currency or zero-interest deposits. It is expected that the rate of return earned on cash should be positively correlated with inflation seen in the economic environment. This makes cash essentially a floating rate instrument with zero duration.

Returns should improve in rising interest rate environments and worsen in lowering interest rate environments. Deflation can make cash particularly attractive; however, it encourages hoarding, not use.

Cash is also known as currency and can only do its job when circulating. Therefore, the fact that the prices of goods will be lower tomorrow encourages hoarding and discourages circulation.

Inflation Effects on (Nominal Fixed-Rate) Bonds

Bond prices and interest rates share an inverse relationship. When interest rates rise, bondholders experience depreciation of the current market value of their instruments. When rates fall, bondholders experience capital gains. This makes bonds favorable to other asset classes in times of falling interest rates.

Inflation Effects on Stocks

Equities tend to outperform their fixed-income counterparts in periods of rising interest rates. Higher-than-expected inflation can be a headwind for equity, although some firms can more easily pass on the higher costs to consumers than others. From a valuation standpoint, both the expected future earnings and dividends of a company and these cash flows’ associated discount rates should rise and fall in line with inflation expectations, netting each other out.

Inflation Effects on Real Estate

Short to intermediate-term nominal cash flows are generally dictated by existing leases that are unlikely to adjust to inflation expectations. Since leases are renewed, they may be increased in line with inflation, allowing real estate investors to increase returns.

Unexpectedly low inflation exerts downward pressure on expected rental income and property value, especially for less-than-prime properties. Landlords may have to cut rents sharply to avoid rising vacancies.

Question

Which asset class is most likely to outperform based on stronger-than-expected deflation?

1. Equities.
2. Real estate.
3. Fixed-income instruments.

Solution

The correct answer is C.

Fixed nominal income means that cash flows are not set on a floating rate, so essentially, they are level and flat in deflation. This means that the cash flows coming in the future will be worth more when they arrive than they are if received today. If deflation persists, fixed-income instruments will outperform. 

A is incorrect. The effect of inflation on equities is mixed and somewhat neutral, depending on the firm in this situation. Inflation may be good or bad for certain companies. 

B is incorrect. Stronger-than-expected deflation would likely suppress rent prices, which are a direct input into the valuation of real estate holdings. Therefore, real estate should not be expected to outperform other asset classes during times of deflation.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (g) Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns