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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for 3/17/2025. I'm Phil Adler. It might be time to take a new look at the relationship between inflation and stock market performance. The old adage is that inflation is bad for stocks. Confluence associate market strategist, Daniel Ortwerth, joins us to suggest it might be wiser today to view equities as an inflation hedge.
Phil Adler:Daniel, there's certainly some evidence for the argument that equities can be an inflation hedge. How does the performance of The US stock market support this argument?
Daniel Ortwerth:Hi, Phil. Until recently, I would say, no. The evidence actually suggests the opposite. Looking at the data going back to World War two, inflation has generally seemed bad for stock markets. When we have seen The United States consumer price index go up, US stock indices have tended to go down or at least underperform.
Daniel Ortwerth:However, the most recent episode of high inflation in The US beginning during the COVID response period appears to have counteracted the long term trend. Since 2021, we have experienced a strong rising stock market together with high inflation. Now we might be tempted to write this off as an anomaly with explanation about how the early years of this decade saw extraordinary circumstances except that it does not stand alone. We have seen other instances of high inflation together with strong stock markets in other countries, and this combines with our knowledge of some of the ways that markets have changed to at least suggest that this may be the first sign of a change in the old relationship.
Phil Adler:What about stock markets in the rest of the world? Are there shining examples of high risers in the face of serious inflation?
Daniel Ortwerth:Yes, Phil. And I'd like to highlight two. The first is Turkey. Despite inflation rates between 4075% for most of this decade, its stock market has performed impressively, solidly exceeding the country's inflation rate. The second is Iran.
Daniel Ortwerth:Data from Iran have been highly questionable due to concerns of government manipulation. But as our recent report on Middle Eastern stock markets details, its market has posted the most impressive recent performance in the region during a period of not only high inflation, but a suffering economy.
Phil Adler:When did this old rule that inflation is bad for stocks originate?
Daniel Ortwerth:Here in The US, the nineteen seventies burned this idea into the minds of American investors. We had just gone through two postwar decades, the fifties and the sixties, in which generally inflation had remained tame and markets had done well. Now this may have lulled investors into a false sense of security, but at any rate, the early seventies witnessed a near simultaneous rebirth of inflation and a rather severe market correction that led to nearly a decade of weak stock performance and disappointing returns. Scorched investors concluded that one caused the other, but this simplistic view overlooks the unique circumstances of the time.
Phil Adler:What was unique about the period of the early seventies in America that led to such a strong negative connection between inflation and stocks?
Daniel Ortwerth:Phil, we had a handful of extraordinary circumstances, and I'd like to highlight four in particular. First, the period began with The United States retreating from Vietnam, which included the wind down of associated expenditures primarily in the defense sector, but rippling through the broader economy. Second, in August of nineteen seventy one, Richard Nixon closed the gold window upsetting financial markets. The effects of this move were further exacerbated by loose federal reserve policy later in the decade, undermining faith in the value of the dollar. Third, in 1973 and 1974, OPEC instituted an embargo on oil exports to the countries supporting Israel, principally The US and The UK, heavily impacting prices throughout the economy and causing a severe recession.
Daniel Ortwerth:Finally, the five years leading up to the oil crisis had witnessed a strong bull market for US stocks with valuations for the most favored stocks of the day known as the nifty 50 reaching more than double the S and P 500 as a whole. Taken together, these and other forces of the time may well have resulted in a bear market regardless of the inflation of the period, and more likely, the factors of the time probably caused both inflation and a down market rather than one causing the other.
Phil Adler:Daniel, in your report, you make a a strong case that regulatory and technological changes in the past forty years in the way stock markets operate have resulted in much greater resiliency for stocks in times of inflation. Remind us how difficult it used to be to buy and trade stocks compared to today.
Daniel Ortwerth:Right. That's a story worth telling because the changes have become so commonplace today that younger investors might not be aware or even be willing to believe how difficult buying stocks used to be. Again, I'm gonna highlight several factors. First, transaction costs have plummeted. Before 1975, commissions on stock trades were fixed by law at levels that often resulted in fees of hundreds of dollars for a trade.
Daniel Ortwerth:By progressive steps over the decades, commissions today are essentially zero. Second, settlement time, meaning the number of days from the order to the purchase or sale of the shares until the payment and the securities actually change hands was five days fifty years ago. We referred to it as t plus five. Gradually, over the years as trading technology has improved, securities regulations have required shorter and shorter settlement times to the point that in 2024, the standard became t plus one. And there is even conversation that we may eventually get to t plus zero.
Daniel Ortwerth:Next, stocks used to be quoted, bought, and sold in increments of an eighth of a share. That means the smallest amount a price could change was 12 and a half cents. This had negative effects on trading volumes and liquidity. Starting in the late nineties, computerization of the process led to decimalization of quotes and trading, which increased liquidity and made the entire process of buying and selling easier. Beyond these changes, Internet technology may have done more than anything to make participation in the stock market easy, accessible, and affordable to virtually the entire adult population.
Daniel Ortwerth:Stock trades used to require relatively exclusive brokerage accounts and telephone communication between broker and client. Now we trade via cell phone. Finally, let's consider the impact of indexing. Index ETFs, which did not exist decades ago, but are now as broadly available and investable as the stocks themselves, give individual investors with modest amount of money the ability to own broad baskets of stocks and achieve diversification as never before.
Phil Adler:So more money flows into US stocks giving the stock market resilience simply today because stock market investing is so easy to do.
Daniel Ortwerth:Money certainly has the ability to more easily flow into the stock market. Consider the similarity to what we used to refer to as making a long distance phone call. Our younger listeners may have never heard of such things, but, Phil, you and I remember those days. If we wanted to make a phone call outside our local area, we had to contact the operator, announce our intention to make a long distance call, provide the number, and pay an extra per minute fee. Step by step, that has changed to the point that I can grab my cell phone and call someone on the other side of the country just as easily and for the same price as calling someone across town.
Daniel Ortwerth:Now I'm still not going to call someone without reason. I'm not going to call someone just for the sake of it, but I don't have to think about all these steps and pay extra fees just to talk to my friend in Pennsylvania if I need to talk to him. Well, I think it's fair to say a person is not going to buy stocks just for the sake of it. But if he or she has a reason to buy them, the old costs and barriers just aren't there anymore.
Phil Adler:Daniel, do you think it's also time to rethink the adage about investing in bonds that investing in bonds provides protection against inflation and is a good way to preserve wealth.
Daniel Ortwerth:It might be. The critical thing to keep in mind is that most bonds provide a fixed return at a set interest rate. Participants in the bond market whose buying and selling produces the market interest rate are making assumptions about a list of things, one of them being the likely rate of inflation over the life of the bond. If inflation winds up exceeding those expectations, not only is the rate of return from interest going to fail to keep up with inflation, but the market value of the bond itself will suffer. If inflation is relatively stable, even if it's high, the bond investor has a fair chance of securing a fair rate of return.
Daniel Ortwerth:However, if inflation becomes increasingly volatile and hard to predict as we think it will, then the risk of the bond failing to compensate for changing inflation increases.
Phil Adler:We began, Daniel, by discussing examples of stock market that have prospered in the face of inflation. But do stock markets also prosper when there is a recession, or is that too much to expect?
Daniel Ortwerth:Phil, I think that is probably too much to expect. Now every recession is different as is every episode of history. But generally speaking, recessions involve declining or at least disappointing earnings. And across nearly all circumstances, we would expect that to hurt stocks. Also, I should point out that we definitely are not saying that inflation is in any way good for stocks.
Daniel Ortwerth:That takes the idea too far. Rather, we are only saying that inflation might not hurt stocks in the future in the same way that it has in the past.
Phil Adler:So can we conclude that while inflation does not necessarily cause recession and shouldn't sideline stock investments, that the fact of recession would be a valid reason to be cautious?
Daniel Ortwerth:Yes, Phil. I think that is a very fair way to say it.
Phil Adler:Do you think continued inflation with no recession is the most likely short term outcome here in The United States?
Daniel Ortwerth:That is still the general consensus as we have this conversation, but the situation is proving extraordinarily fluid. The news flow in recent weeks has been very dynamic and unpredictable, and it seems as though this new level of uncertainty will continue. We view the risk of recession as higher than it was at the beginning of the year without necessarily having become the most likely scenario.
Phil Adler:One more question, Daniel. Broadly speaking, should investors who might worry about a rising risk of recession be emphasizing dividend paying stocks right now?
Daniel Ortwerth:Broadly speaking, Phil, I think that is a reasonable view. Within the asset class of equities, dividend paying stocks do provide an alternative source of value to just relying on the appreciation of the stock price. In a recessionary environment, the risk the investor faces in equities is heavily weighted on the price of the stock and the possibility that it may suffer. Of course, a company can cut its dividend, and that happens in the real world even more in recessions. Still, within our choices among equities, dividends provide at least some protection against a decline in price.
Phil Adler:Thank you, Daniel. This week's report is titled Equities as an Inflation Hedge? You can find a link to the written report on ConfluenceInvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.