Public finances are like stocks

In theory, inflation should be good for public finances. At least in the short-term tax revenues and revenues from sales taxes and VAT should increase as the prices of goods and services and wages rise. This should reduce budget deficits, but in the long term the government must pay higher wages to civil servants and purchase goods and services at higher prices as well, negating this short-term boost. That is theory. In the real world, it is not so easy, and stock market investors should know that because the same applies to equity returns.

One of the common misconceptions about stocks is that they are a good inflation hedge or indeed a ‘real asset’. In theory this should be true because shares are stakes in companies and companies consist of buildings, machinery, and other real assets. Plus, they produce goods and services that are sold in the real world. So, if inflation rises, revenue growth (in nominal terms) should rise and earnings growth should accelerate compensating investors for the rise in inflation.

That this theoretical intuition does not work in practice is so easy to show that I am always surprised when people claim that stocks are a good inflation hedge. I can forgive retail investors and laypeople when they make these claims but when I hear advisers and professional investors say that I have to shake my head.

Below is the real return after inflation of the S&P 500 for different levels of inflation.¹ Note how real returns decline as inflation rises and then fall off a cliff once inflation surpasses 5% or so. In fact, real returns are below long-term averages as soon as inflation rises to above 3% or so. The inflation protection in stocks is very limited and disappears altogether once investors need it the most, when inflation rises above 5%.

Real return of S&P 500 in different inflation regimes

Source: Bloomberg, Liberum

What causes this decline in return is that businesses face a margin squeeze as soon as inflation starts to climb above 3% or so and that profit squeeze becomes significant for inflation above 5%. In essence, they cannot pass on higher costs and wages to end customers fast enough to cover the cost increases. Or they may be unable to pass higher costs at all because end customers face their own cost pressures and simply cut back on consumption and investment thus creating a decline in revenues for businesses at the same time as they face rising costs.

To switch to public finances, Clémence Briodeau and Cristina Checherita-Westphal examined the impact the most recent inflation bout had on government finances in the Eurozone. As inflation increased, governments indeed have higher tax revenues in the short term while expenditures remained relatively stable. But once inflation rose above 4% all kinds of weird effects started to undermine the benefits to fiscal balances.

First, when inflation rises above 4% or so, there are more applications for unemployment benefits and the costs of supplying social welfare start to rise very fast. This reflects the economy cooling off and people losing their jobs while facing higher costs for food and other essentials of life.

Second, if inflation rises to extreme levels, the government has to step in and provide relief to households from the cost-of-living crisis. In the past couple of years governments had to provide all kinds of support payments to ease the impact of high energy prices. In the 1970s, governments provided subsidies to reduce the cost of food items and other basic necessities, etc.

These support measures are not discretionary. Governments must step in to support the economy or they face an even faster and deeper recession and a corresponding drop in tax revenues. Or they face defeat at the next election and what is an ex-MP to do in life when he has been voted out of office? They are basically unemployable given their usually abysmal track record while in office. So better to rescue the economy with other people’s money to secure their own jobs.

The result is that once inflation is too high, public finances deteriorate rapidly and dramatically, which just shows once again how important inflation targeting is for the economy.  

1. For the curious, here is the same chart based on real total returns including dividends:

Real total return of S&P 500 in different inflation regimes

Source: Bloomberg, Liberum