Equities as an inflation hedge

My first post on this subject was in early October. Time for an update, since the meme continues.

The above chart compares the S&P 500 to the bond market's forward-looking inflation expectations. Since the third quarter of last year, both equity prices and inflation expectations have moved higher in a meaningful way. It would seem that the Fed's quantitative easing efforts deserve some credit (or should I say blame?) for this. Higher equity prices owe more to rising inflation expectations than to stronger growth expectations. Inflation are not necessarily bad for equities, as I explained in my earlier post, because corporate earnings should tend to rise as the price level rises.

Another "benefit" to higher inflation is that it boosts tax revenues. Incomes tend to rise with increases in the price level, and that moves people into higher tax brackets (thanks to our progressive tax code), with the result that federal revenues rise without the need to increase tax rates, even if the economy remains weak. That's been the story for the past few years: a very weak recovery but with ongoing inflation of 2% or so has caused federal revenues to increase at a 6.3% annualized pace over the past three years, even as nominal GDP has grown at only a 4.2% annualized pace.

Another "benefit" to higher inflation is that it reduces the burden of federal debt. That is especially the case today, since yields on Treasuries are significantly lower than current inflation. Negative real interest rates allow the federal government to pay back its debt with cheaper dollars. This, together with the revenue-boosting effect of higher inflation can result in a substantial decline in the federal deficit burden. Already we have seen the federal deficit fall from a high of 10.5% of GDP to today's 7.0%.

While it's good to see debt burdens decline—especially since they are so large—inflation is not the best way to do it. Today's 2-3% inflation, in the context of negative real interest rates on almost all maturities of Treasury securities, is transferring significant wealth from the private sector to the public sector. Over time, this will result in economic growth that is disappointingly slow. And of course that is what we have seen so far in this recovery, the weakest one in modern times.

I don't see things changing meaningfully as a result of the fiscal cliff negotiations. Both fiscal and monetary policy are contriving to continue to transfer wealth to the federal government, and this will keep the economy weak for the foreseeable future. This doesn't mean a recession, just more of the same very slow growth we have seen in recent years.

So I think it still pays to be an equity investor, even though the economic outlook is not very bright. Equities are relatively cheap (i.e., PE ratios are below average at a time when corporate profits are very strong) and they are thus one of the cheaper inflation hedges available to investors at this time.