Are you feeling lucky?

Even though equity returns provide “blue sky”, that blue sky comes with the heavy price of volatility; especially volatility to inflation. This brief study shows that long term data supports the premise that inflation and equity returns remain largely unrelated, over the short, medium, and longer terms. Equities struggle to beat CPI plus 4%, and while differences may exist between Australia and the US, especially with regard to taxation, the longer term facts are hard to ignore. If you can earn roughly an equity return in a senior position within the capital structure, that ILB return beats equity returns hands down. Indeed, you have to be “feeling very lucky” to buy equities ahead of ILBs with a 4% yield above inflation. It is a matter of time before investors compete away the opportunities in the ILB market.

In the analysis we now present analysis for three different rolling time frames, which all show how equities struggle to beat inflation plus 4%. The three rolling time frames are as follows:

• One year,
• Five years, and
• 10 years.

One year results

Generally, the poor record of equity returns relative to the US CPI is apparent in the annual comparison of S&P returns to the annual CPI. Specifically, notice the large variation in return, relative to the US CPI plus 4%, as shown in Figure 1 below,

Figure 1

Also of note is the frequency, or chance that equities outperform the CPI by an amount greater than 4%. Here, the chances favour equities (55% versus 45%), yet the risk of underperformance is very high, as figure 2 shows below,

Five year results

Looking at longer rolling time frames, the poor record of equity returns, relative to the US CPI plus 4% remains in the five year comparison. Specifically, notice the large variation in return, relative to the US CPI, as shown in Figure 3 below,

Figure 3

Looking at the frequency, or chance that equities outperform the CPI by an amount greater than 4%, the chances once again favour equities (52% versus 48%), yet the risk of underperformance is very high, as figure 4 shows below,

Figure 4

10 year results

Generally, the poor record of equity returns, relative to the US CPI remains even over a rolling 10 year period. Specifically, notice the large variation in return, relative to the US CPI., as shown in Figure 5 below,

Figure 5

Looking at the frequency, or chance that equities outperform the CPI by an amount greater than 4%, the chances favour equities (59% versus 41%) but again the risk of underperformance is very high, as figure 6 shows below.

Figure 6 

Conclusion

As we indicated last week, inflation needs to be taken seriously in the construction of portfolios, and this brief study emphasises that one needs “to feel lucky” when investing in equities, if one wants to beat inflation by 4%. Equities can beat that target, but can also fail, and fail badly. We still wonder why one would assume all the risk of equity investing, especially the risk that inflation erodes the value of saving, when ILBs provide such an effective form of inflation insurance.

We would recommend that investors observe the deep value in ILBs above 4%, as opposed to relying on “luck”, in almost every time frame. Moreover, as investors become aware of the value of this inflation insurance, through ILBs, the current yield above inflation of between 3% and 4% is likely to fall, as demand inevitably exceeds the supply of ILBs.

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