Are stock investments a good hedge against inflation?

In my previous post, I mentioned that stocks should provide a good hedge against inflation. If you don't believe me, consider the following quote taken from "Defying Hitler: A Memoir" by Sebastian Haffner. Haffner (real name Raimund Pretzel) was a German journalist who fled Nazi Germany in 1938 and wrote a memoir in the next year, which was only published after his death in 1999 (facinating book). As you may know, Germany was characterized by a period of hyperinflation between 1921 and 1924 which destroyed the savings of many Germans. According to Haffner, this is how people dealt with this hyperinflation:

Anyone who had savings in a bank or bonds saw their value disappear overnight ... The salary of sixty-five thousand marks brought home the previous Friday was no longer sufficient to buy a pack of cigarettes on Tuesday .. What was to be done? Casting around, people found a life raft: shares. They were the only form of investment that kept pace – not all the time, and not all shares, yet on the whole they managed to keep up. So everyone dealt in shares ... Day-to-day purchases were paid for by selling shares. On wage days there was a general stampede to the banks, and share prices shot up like rockets.

Why would stocks provide a good hedge against inflation? The value of a stock is determined by the profits of the firm. Profit is the difference between revenues and costs. If there is inflation, the costs of the firm will increase, but the price of the goods sold by the firm will also increase. As a result, the profits of the firm will not be affected by inflation. At least, that's the theory. Is this also true in the real world? My colleague Jan Annaert and I checked the relation between yearly real (i.e. adjusted for inflation) stock returns on the Brussels Stock Exchange and inflation for the period 1838-2008. If stocks provide a good hedge against inflation, real stock returns should not be significantly affected by inflation. Indeed, as you can see in the first figure below, there doesn't seem to be a clear relation between real stock returns (y-axis) and inflation (x-axis), except for some years in WW1 and WW2 which were characterized by very high inflation and low stock returns (but also note 1940: very high stock returns despite high inflation).

On the other hand, the second figure below shows that real fixed returns (short-term) are clearly negatively affected by inflation. This makes sense, since a fixed interest does not change when inflation goes up (at least to the extent that inflation is unexpected: if investors expect inflation, they will demand a higher interest rate before they are willing to invest). Note that holders of investments with fixed interest will benefit when there is deflation: the interests they receive become more valuable. This (partly) explains why bond prices have gone up so much in recent years.

Another interesting feature of the figures are the many red dots with negative inflation (deflation). Modern investors are very much conditioned by the high inflation in the 1970s and early 1980s, but before WW1 deflation was quite common. But that's another story.

Is war good for the stock market?

I’m currently rereading “Antifragile” by N.N. Taleb, which I find an insightful book. It’s also fun to read, if you don’t mind his rants against economists, Harvard professors, bankers, journalists … (the list of professions to which Taleb is averse is substantial). In this book, Taleb describes how traders lost millions of dollars when the Kuwait War started in January 1991. They were betting that the oil price would rise when the war started. Instead, the oil price collapsed from around $39 a barrel to almost half that value. Why did the oil price not rise at the start of the war? Because people expected this war to start, and the expectation was already incorporated in the oil prices.

This reminds me of a strange phenomenon I observed in my own research: the outbreak of World War II led to a dramatic increase in stock prices on the Brussels Stock Exchange. The graph below shows stock returns in 1940 (weighted average of all Belgian stocks). The exchange was closed for a few months in the summer when Germany invaded Belgium, but when it reopened stock prices went up by 30% in September, 18% in October and 37% in December! How could WW2 make stocks so much more valuable? As the Kuwait war, this was an expected war. However, the very swift German victory, which apparently was excellent news for Belgian business, was unexpected. So, stock prices didn't go down because the outbreak of war was expected, but they went up because it led to much less fighting and destruction than stock market investors had anticipated (at least in the short run, no one knew what was still coming).

F. Baudhuin, a contemporary Belgian economist, provides another explanation why the stock market boomed after the start of WW2. In a book written shortly after WW2, he argued that Belgian investors had learned from the first World War that war leads to high inflation. Inflation destroys the return on fixed investments such as bonds and savings accounts, while stocks provide a good hedge against inflation. Based on their experiences during WW1, investors at the beginning of WW2 massively invested their money in stocks to protect themselves against inflation, according to Baudhuin. Hence the dramatic increase in stock prices after the war broke out.