The one good thing about high inflation

High inflation causes lots of problems which is exactly why central banks target low and stable inflation in the first place. But there seems to be at least one thing that gets better when inflation and – more importantly in this case – inflation expectations increase: People hold more stocks.

First, let me re-iterate what seems to be still not always common knowledge. Equity investments have higher returns when inflation rises, thus creating some indirect hedge against inflation. But only to a point. Once inflation surpasses some 4% to 5% companies struggle to pass on rising input costs to end customers and experience a margin squeeze. Simultaneously, discount rates for future cash flows increase so much that valuations start to decline a lot. The combination of the two effects means that once inflation is persistent at levels above 4%, equities are a poor investment and not an inflation hedge at all.

But because people believe in equities as a high return asset that can help in inflationary periods, rising inflation typically triggers an increase in the inflation investors expect, which in turn motivates investors to shift more of their portfolio into equities. Qingyuan Yang from the University of Lugano, Switzerland, looked at the investment behaviour of Dutch households and their inflation expectations. He found that Dutch households show the same biases that are typically observed in other countries in Europe and North America:

• Many households overestimate future inflation. The average inflation expectation for Dutch households was 2.8%, well above the realized inflation in the Netherlands. This is mostly driven by a minority of households of about 25% that think inflation is going to be 3% or higher.

• Very few households participate in the stock market. Only about 18% of all Dutch households invest in equities (either directly or indirectly via funds). That is driven mostly by nonparticipation by poor households which don’t have enough financial security to invest excess savings in equities. For comparison, an old study by Luigi Guiso and others shows participation rates of 16.9% for the Netherlands, 17.6% for Germany, 12% for the UK, and 38.6% for the US in the year 1998.

• Most portfolios are incredibly concentrated with 44% of households holding just one single stock and some 70% holding three stocks or less. Also, 57% of households hold only one equity fund, and 77% hold one or two funds.

Given these low participation rates and the low diversification in investor portfolios, every increase in stock market participation and additional investments in existing stock market portfolios is likely to improve returns.

In his study, Yang finds that indeed, if investors expect higher inflation, they start to look for investments that generate higher returns to compensate for higher inflation. A one percentage point increase in inflation expectations leads to a 2.8 to 3.4 percentage point increase in the share of households investing in stock markets and a roughly 0.3 percentage point increase in equity exposure for those households that already invest in stocks.

The latter is a rather small effect, but if more households participate in the stock market because of high inflation, that makes a big difference for retirement savings – at least if investors who newly invest in stock markets stay in the market and don’t get hammered by declining share prices and then give up again. And that’s the unfortunate side effect that we experience this year. The high inflation has triggered not only higher inflation expectations but also a bear market in equities. We don’t know how many investors have contemplated buying into stocks in the first half of 2022, but I guess not many given the headlines everywhere about a cost-of-living crisis and tumbling share prices. But those that have bought into stocks in recent months for the first time, will probably become very risk-averse investors in the future given their initial experience with stocks has been this bad.