Show me the money
Brace for poor returns as inflation rises
Key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures
By TEH HOOI LING
SENIOR CORRESPONDENT
THE inflationary pressures are on! 'Government raises inflation forecast', screamed the headline in The Straits Times yesterday. 'New official projections have confirmed that rising prices will be the key economic issue this year and a major focus for today's Budget,' the news report said. 'The government yesterday raised its inflation forecast for the year by one percentage point to between 3 per cent and 4 per cent.'
The key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures, said Ravi Menon, Permanent Secretary for Trade and Industry.
Except for seven quarters between the second half of 2007 and the first quarter of 2009, Singapore has managed to keep the growth of its consumer price index (CPI) below 3 per cent since 1995. In Q3 2007, the CPI climbed to 3.17 per cent and rose to hit 7.5 per cent in Q2 of 2008.
But thanks to the global financial crisis, which effectively threw a soaking wet blanket on the overheated prices, the CPI eased to 0.17 per cent by Q2 2009. It was then followed by two quarters of negative growth.
But by Q2 2010, inflation reared its ugly head again as prices climbed more than 3 per cent year-on-year. It rose to just under 4 per cent by the final quarter of last year.
On Thursday, I received an e-mail from a reader asking if I could give him some insight/opinions regarding Singapore's record inflation rates in 2008 and which stocks outperformed during high interest rates and which did poorly.
I downloaded Singapore's inflation numbers since 1973, and the individual stocks' prices at various times when inflation was either rising and falling. I also downloaded the Straits Times Index (STI) as calculated by Datastream since 1973.
First up, I decided to look at how the general market performed during periods of high or low inflation.
Using the quarterly CPI numbers, I matched the quarterly returns of the STI with the CPIs for the corresponding quarters. For example, the CPI for Q1 2001 would be matched with the STI return for that quarter.
The assumption is that there would be monthly inflation numbers being released and the market would have an inkling of where the general price levels are headed. Stock market prices would then adjust accordingly as the quarter progressed.
The numbers that the data churned out showed clearly that inflation is bad for stock prices. I broke down the year-on- year change in CPI into eight groups: those below -1 per cent growth; from -1 to 0 per cent; 0-1; 1-2; 2-3; 3-5; 5-10; and those above 10 per cent.
As you can see from the first chart, the mean and median three-month returns of the STI in general get progressively smaller as inflation rises. For example, between 1973 and now, there were eight quarters when the CPI fell by more than one per cent from a year ago. The average and median return of those eight quarters were 11.2 per cent and 10.7 per cent respectively.
Meanwhile, there were 13 quarters when the CPI fell by between one and zero per cent. The average and median returns for those quarters were 9.9 per cent and 12.2 per cent respectively.
Recent examples of such quarters were the third and last quarter of 2009 when the CPI was -0.37 per cent and -0.73 per cent respectively. The returns for STI in those two quarters were 14.1 per cent and 7.6 per cent.
In Q1 2007, the CPI slid by 0.17 per cent. In that period, the stock market climbed by 8.3 per cent. Once the CPI climbed to the zero to one per cent range, the STI returns fell to about 5 per cent.
Between one and 10 per cent of inflation, market returns fell to between 0.5 and 3 per cent. And on the eight occasions when inflation surged beyond 10 per cent - that happened in the 70s - the average and median return for the STI were -10.3 per cent and -11.4 per cent respectively.
The third chart shows market valuations, as measured by the price-earnings (PE) ratio, getting lower the higher the CPI went. And we are now moving into the 3 to 5 per cent inflation range, when the market PE dropped rather significantly! But the thing is, current market PE wasn't high to begin with.
This phenomenon is observed in other markets as well, and financial economists find it surprising. After all, stocks, as claimed against real assets, should compensate for movements in inflation.
So given the negative relationship between short-term stock returns and inflation, the stock market is not even a partial hedge against inflation. A negative relationship implies that investors whose real wealth is diminished by inflation can expect this effect to be compounded by a lower than average return on the stock market.
The thing is inflation gets factored into nominal interest rates which are used to discount the future cash flows of companies to arrive at their current present value. All things being equal, the higher the discount rate, the lower the net present value of the company.
Of course, in an inflationary environment, companies would also have to contend with higher costs, be they manpower, raw materials or others. But what if the companies have the pricing power and are able to pass the higher costs to consumers?
Well, even if companies are able to maintain their margins, or in the optimistic scenario improve them, the higher discount rate would, in most likelihood, result in companies having lower net present value.
With that understanding, perhaps we can appreciate why funds are reversing out of fast growing Asia which are grappling with inflation, and heading toward the developed markets and to Japan.
Of course, inflation doesn't stay high forever. If prices increased sharply today, next year this time, we will measure the increase from today's higher base and the quantum may not be as high as a result.
And other studies have shown that over the long term, stocks do compensate for inflation. Studies in countries which suffered bouts of high inflation in Latin America also found stocks to yield real positive returns.
Now back to the reader's question: Which stocks did well in 2007/8 when inflation spiked up? Well, that coincided with the global financial crisis, and between end-September 2007 and end-September 2008, only 25 stocks out of 700- plus listed on the Singapore Exchange managed to chalk up positive returns.
The top performing companies during that period were from varied industries: RH Petrogas which deals in electrical equipment; Portek, which is in transport services; FDS Networks in computer services; Transcu in recreational services, ISDN Holdings in business support services; MAP Technology in computer hardware; Riverstone in medical supplies; and Metax Engineering in industrial machinery.
So it would seem that it was company specific news which drove the stock prices. But normally, it is accepted that resource providers would benefit more in an inflationary environment, so too technology and consumer products.
Meanwhile, utility and telecom companies typically are viewed as not having the pricing power to battle inflation and property developers don't generally do well when interest rates rise. Neither do real estate investment trusts which are raking it in now given the benign interest rates.
The writer is a CFA charterholder
