Equity-Inflation Volatility

The world’s financial markets have had a tough start to the year. The global economy is facing an unprecedented combination of major risk factors including the pandemic, the Ukraine-Russia war, and inflation. However, the pandemic is receding, and while we expect Covid-19 variants to continue to circulate in the economy for many years to come, the developed markets seem to be getting closer to learning to live with it. That should mean more muted reactions from the markets as these variants make their way through the world population. For example, Germany has been recording nearly 300,000 new infections per day (a record), but the death rate is at an all-time low. Cases are also climbing dramatically in Austria, the Netherlands, Switzerland, France, Italy, and the UK. Nevertheless, Covid restrictions are being dropped throughout Europe and financial markets there have been rallying in recent days.

The war in Ukraine, while causing a devastating humanitarian crisis in that country, will likely have a transitory effect on the financial markets. Both Russia and Ukraine are relatively small economies from a global perspective. The Russian economy makes up less than 2% of global GDP and is close in size (but smaller) to the economy of South Korea. The Ukrainian economy is only about one tenth as large as the Russian economy and roughly the same size as the economy of Iraq. While there will be substantial switching costs as many Western companies adjust to avoiding doing business in these countries (and possibly Belarus) and re-align their supply chains and logistics infrastructure, these should also be transitory costs. Recent rallies in the global financial markets appear to reflect this.

The one risk factor that remains and is likely not transitory is inflation. Why inflation is a risk factor is curious still. After all, if we consider a company’s profits as simply revenues minus expenses, and inflation hits revenues and expenses equally on a percentage basis,[1] then the company’s profits should rise in proportion to inflation, and therefore so should its stock price. But we’ve seen the global markets sell off substantially due to inflation risk. Why?

The answer to this question is that it’s not inflation itself but inflation uncertainty, or volatility, that creates financial downside. In the example above, we assumed that the level of inflation is perfectly known in expenses. In that scenario, the company then simply passes on that same level of inflation to its customers in the form of proportional price increases, thus resulting in proportionally higher profits. However, consider the more realistic case where the company doesn’t know exactly what the level of inflation will be in the coming year. In this case, the company must make a forecast.

So, when determining annual salary increases for its employees the company must forecast what inflation will be in the coming year. But suppose the inflation forecast is wrong and the salary increases that are too high (actual inflation comes in lower than the forecast). In this scenario, the company won’t be able to pass on the increased salary expenses to its customers through proportionally higher product prices. If it does, customers won’t buy as much product. However, if it doesn’t increase prices sufficiently it can’t cover the higher salaries. Either way, profits will be lower than the markets would expect. Thus, the company ends up stuck between the proverbial rock and a hard place.

On the flip side, suppose that the company underestimates inflation. Then, it ends up handing out salary increases that are lower than the price increases it can pass on to customers. This would result in higher-than-expected profits.[2]

Investors would see the higher volatility in corporate profits as additional risk that they bear in holding the company’s stock through periods of inflation uncertainty. Therefore, ex-ante the price they would be willing to pay to purchase the company’s stock would be lower.

This effect of inflation uncertainty is what every firm would face to varying degrees, and therefore equity markets would drop.

The second channel for inflation uncertainty to affect stock prices is through the US central bank, the Federal Reserve (the Fed). Inflation uncertainty also makes it more likely that the Fed makes mistakes in forecasting inflation. The Fed’s mission is to fight inflation by increasing interest rates to slow down corporate and consumer spending, thus causing an economic slowdown, which in turn would result in a slowing of price increases. If the Fed gets its inflation forecast wrong, it could slow down the economy too much or too little. Investors in equities now have another risk that they must bear — higher volatility of corporate profits due to higher volatility in economic growth. In addition to erring on slowing the economy the right amount, the Fed would end up increasing inflation volatility as companies would now not only have to forecast inflation but also how much or how little the Fed is going to increase interest rates. All of this too would cause investors to be willing to pay less for holding equities, thus causing equity markets to drop.[3]

So, it isn’t inflation itself that creates the problem. If inflation were high but stable and predictable, there would be little impact on the economy and the financial markets. However, with higher inflation also comes higher inflation uncertainty, and this is the real problem that companies, and the Fed must deal with. Furthermore, history teaches us that inflation volatility (as well as inflation) isn’t something that can be brought down both quickly and painlessly. It will either take time to bring down while we have slow economic growth, or it will come down quickly but with a substantial economic contraction. Another rock and a hard place.

Footnotes

[1] Inflation may affect each of these unevenly initially but companies in aggregate should be able to raise prices proportionately with their expenses in the long run.

[2] Another result would be that some of its employees would leave for other jobs to avoid the drop in their purchasing power (most likely the most talented employees as these are the ones that will have the easiest access to other job opportunities). This could result in lower product quality and lower long-run profitability. Inflation volatility is likely one of the reasons for the high turnover firms are seeing in their employee base currently.

[3] Another important factor currently in play is the problem the Fed has with its oversized balance sheet (currently at $9 trillion). The Fed needs to shrink its balance sheet (and has announced that it will). Of course, this would mean the Fed would be selling risk assets into the markets at precisely the time when the markets are already poised to drop due to inflation uncertainty, thus potentially amplifying any market drop.