The Ability of Stocks as an Inflation Hedge
Abstract: During inflationary period, whether stocks can be used to insulate investors from the potential inflation risk worth investigating. Based on Fisher Hypothesis, overwhelming empirical studies have been focused on the exploration of relationship between stock returns and inflation. This essay strives to give a thorough and in-depth literature reviews on this issue. Considering the key horizon effect, empirical studies are categorized into two groups, which are short-horizon studies and long-horizon (co-integration) analysis. Although there appears to be several deviations, the mainstream results in existing literatures show that the ability of stocks as an inflation hedge is rejected in the short-run, but when it comes to long horizon, stocks' inflation-hedge effect is obvious and valid. This horizon-related response pattern of stock returns to inflation is very important for investors who have long-run perspectives.
: inflation, hedge, stock returns
The Ability of Stocks as an Inflation Hedge
This project gives a critical evaluation of existing literatures with respect to the issue of whether common stocks have the effectiveness to hedge against inflation, and to what extent they can be used to reduce investors' risk due to the uncertainty about the future price level.
All the relevant studies are based on the original Fisher Effects which presents a positive relationship between nominal interest rate and expected inflation rate. Applying the Fisher Hypothesis to stock markets, it implies that stocks can be act as a perfect inflation-hedge. The inflation hedge effects have different criteria according to various studies. Besides the traditional understanding of inflation-hedge, there are other two groups of the explanations which are developed by Reilly, Johnson et al. (1970, 1971) and Branch (1974), separately.
The extension of the Fisher Effects to stock market has suffered wide controversies. The inverse relationship found in short horizon studies rebuts stocks' ability of inflation-hedge. Divergences in what induces this surprised inverted response exist, such as the proxy hypothesis explanation introduced by Fama (1981), the market inefficiency concept (Boucher, 2006) and so on. On the contrary, when the study horizon becomes much longer, different results appear. Stocks show positive response to inflation, confirming their ability as an inflation-hedge. According to this finding, investors can be successfully protected against the inflation shock by choosing an optimal assets portfolio.
The exploration on this issue is still ongoing and requires some further evidences. Future research can pay more attentions to the joint-effects of different variables to stocks' inflation-hedge effectiveness.
Investors always confront the potential inflation risk which could greatly depreciate their real wealth, thus an effective tool must be found to help them protect against the possible future inflation shock. Given this situation, the study of the relationship between stock returns and inflation becomes increasingly significant, as it determines whether stocks can be used as a perfect inflation-hedge tool for investors. The relationship between assets returns and inflation was firstly demonstrated by Irving Fisher (1930) which originally referring to interest rates. It states a one-to-one positive relationship between nominal interest rate and inflation rate. Extending Fisher Effects to risky assets, if it still holds, then stocks investment can be successfully used to insulate investors from the inflation risk (Fama and Schwert, 1977).
The empirical evidences on the issue of whether stocks show obvious abilities of hedging against inflation are far from conclusive. The implications of various results are obscured until the short horizon and long horizon studies are separated. Thus, empirical studies are categorized into two groups, which are short-horizon studies and long-horizon (co-integration) analysis (Schotman and Schweitzer, 2000). Overall, adequate empirical evidences suggest that the ability of stocks to hedge against inflation risk is rejected at the short horizon, but stocks turn out to be an effective inflation-hedge when the horizon becomes longer.
This essay further explores whether common stocks have the effectiveness to hedge against inflation, and to what extent they can be used to reduce the risk of investors' wealth loss resulting from the uncertainty about the future price level, meanwhile, a critical evaluation of various literature reviews on this issue is also involved.
The remainder of the essay is organized as follows: section two discusses the theoretical base and also the definition of a stock as an inflation-hedge. Section three provides critical literature reviews concerning the relationship between inflation and stock returns. The results are classified into two main groups. First group shows inverse relationship captured from short horizon studies. Some plausible explanations about this inverted effect are also provided. Opposite is positive relationship through long horizon analysis. Based on this result, further studies are conducted to help choosing optimal investment portfolio to maximize the inflation-hedge effects. Finally, section four gives the conclusion and some implications.
2. Theoretical Base
2.1 Fisher Effects and Its Extension
The relationship between nominal returns on assets and inflation was firstly introduced by Irving Fisher (1930) which originally referring to interest rates. According to Fisher Hypothesis, the nominal interest rate consists of two parts which are real interest rate as well as expected inflation rate. As the real interest rate is usually invariant, therefore, there must be a positive one-to-one relationship between nominal interest rate and expected inflation rate.
Fisher Hypothesis only focuses on the effects of the risk-free assets responds to the change of inflation. From then on, wide interests have been raised towards the relationship between inflation and risky assets. Two main contributions are made by Bodie (1976) and Fama and Schwert (1977), who extended Fisher Effects to wider asset classes, such as common stocks, bonds, etc. A positive relation between stock returns and inflation must exist, which further means stock can be used as an inflation-hedge tool, if the Fisher Effects can be effectively applied to stock market. However, the extension of the Fisher Effects to stock market has suffered wide controversies as divergences in results are found among various empirical studies.
2.2 Explanation of inflation-hedge
There are three main groups of the definitions of an inflation-hedge. The traditional concept of an asset as an inflation hedge refers to the increase of the value in assets must be at least not lower than the loss caused by the increasing price level.
Reilly, Johnson and Smith (1970, 1971) further modified the traditional definition and stated that inflation-hedge meant protection against inflation risk, ensuring that the ‘real' value on stocks is not below a lower bound. They divided the concept into two parts, which are complete inflation hedge and partial inflation hedge, separately. In details, a stock as a complete inflation hedge indicates that its ‘real' rate of return, which is expressed as the nominal rate of return adjusted for inflation rate during the same period, must be larger than its normal rate of return without the existence of inflation. By contrast, if the nominal return only equals to the normal required return, then it shows that the stock only has partial inflation-hedge effectiveness (Reilly, Johnson and Smith, 1970). However, Branch (1974) developed a different explanation that a stock has the ability of hedging against inflation only if its real return is independent of the inflation rate, which is consistent with the results conducted by Fama and MacBeth (1974) and Oudet (1973). Most studies use this explanation of inflation-hedge as it is the most general and reasonable one. Those three groups of explanations of inflation-hedge are not mutually exclusive, so it is possible for one stock act as an effective inflation hedge satisfy more than one of those concepts.
3. The Relationship between Stock Returns and Inflation
The horizon sensitivity is vital in considering the effectiveness of inflation hedge when investing in stock market, as investors care not only the short-run effects but also the long-horizon performances. Horizon effect is a key factor which would significantly determine stocks' hedge potential. Considering that, empirical studies can be categorized into two main groups, which are short-horizon studies and long-horizon (co-integration) analysis. Overall, the most typical finding is that the ability of stocks to hedge against inflation risk is rejected for the short horizon while they work effectively when the horizon increases.
3.1 The Inverse Relationship: Empirical Evidence from Short-Horizon Studies
There do exist some studies supporting the Fisher Effect at the short horizon, such as Kim and Francis (2005) who indicated a positive response of stock returns to inflation at one-month scale, however, most studies show the Inverted Fisher Effect over the short horizon, meaning stock returns are inversely related to the inflation, when using monthly or annual inflation and stock return data covering 10-20 years.
Jaffe and Mandelker (1976) firstly found that there was an obvious inverse relation between stock returns and inflation rate for the period of 1953 to 1971. This finding is completely inconsistent with the Fisher Hypothesis and implies that investors' loss on real wealth caused by inflation was accompanied by a lower return on stock market. During the same period, Bodie (1976) extended the study and indicated that two parameters determined the effectiveness of stocks' inflation-hedge. The first one was the ratio of the variance of real stock returns without considering inflation to the variance of unexpected inflation rate. The larger this ratio was, the more confident to reject the hypothesis that stocks can effectively hedge against inflation. Another parameter was the difference between nominal stock returns and the coefficient of unexpected inflation in the regression equation for real stock returns (Bodie, 1976). The absolute value of this difference was positively related to the ability of inflation hedge. These two parameters were then estimated by using annual, quarterly as well as monthly data during the period of 1953 to 1972. The result shows that negative relationship exists in the short run, disturbing the conclusion driven from Fisher Hypothesis. This finding is also supported by Nelson (1976) who investigated the issue using the monthly data during the post-war period.
Another special finding is captured by Amihud (1996) who focused on the event studies. He explored the reaction of stock price after the exact day of inflation announcement and also reported a negative and significant relationship between inflation and stock returns. Choudhry (2001) hold the same opinion and proved the existence of a significant but negative effect at short horizon, providing no evidence showing that stocks can be used to protect investors from inflation risk.
There are fewer consensuses on what causes this inverse relationship. The earliest explanation was advanced by Modigliani and Cohn (1979). They maintained that the negative stock return-inflation relation was caused by the misuse of nominal discount rate to discount real cash flows. Thus, stock prices were totally distorted by the money illusion. Such money illusion hypothesis was supported by Ritter and Warr (2002) who presented the cross-sectional evidence in their studies. In 1980, Feldstein used a new tax-effect hypothesis to rationalize the phenomenon of anomalous stock return-inflation relation. Inflation can influence taxation which was closely related to inventory and depreciation, thus this inflation-related distortion negatively affected real stock valuation (Feldstein, 1980). Different from previous explanation, Fama (1981) gave another plausible explanation known as the ‘proxy hypothesis', indicating that inflation merely proxies for anticipated economic activities. According to Fama (1981), stock prices were positively related to real economic activities, but real economic activities were negatively related to inflation, as a result, there was no doubt that a inverse relation between inflation and stock returns appeared. Fama's concept is much more reasonable and thus gets lots of supports from other scholars, such as Geske and Roll (1983) and Boudoukh and Richardson (1993). More recently, a new interpretation is introduced which concerns market inefficiency. Efficient market hypothesis (EMH) indicates that financial market is efficient as the asset prices have already reflected all the market information. However, in reality, the stock market is obviously inefficient, that is why anomalous stock return-inflation relation is observed. Boucher (2006) claimed that the failure of stocks acting as an inflation hedge coincided with the behavioral finance theory, showing market is inefficient and investors are susceptible by various cognitive biases. This new concept is quite interesting and novel as it integrats the two hottest research fields today, which are EMH and Behavioral Finance.
3.2 The Positive Relationship: Empirical Evidence from Long-Horizon and Long-Term Analysis
Although a large amount of studies indicate the existence of negative co-movement between stock returns and inflation, they are all conducted over relatively short time horizon. Therefore, these results do not capture any long-term relations between those two variables. As a result, it is crucial to find out how stock prices react to inflation over long horizon. This long-horizon study can offer great help in providing benchmarks for investors to decide suitable asset allocation (Yeh and Chi, 2009). Boudoukh and Richardson (1993), Jaffe and Mandelker (1976) demonstrated that in order to better work out the long-run stock return-inflation relation, a longer sample period of 100 to 200 years must be used.
Extensive studies show that positive relationship occurs between inflation and returns in stock market at long horizon. Early in 1976, Jaffe and Mandelker studied the data over a long time period (1875 to 1970), and found an obvious positive relationship between the two variables, which affirmed the original Fisher Hypothesis. This positive relation is further confirmed by Boudoukh and Richardson (1993), who investigated both one-year and five-year stock returns during almost one hundred years (1802-1990) in United Kingdom and United States, and concluded that there was a positive long-run inflation effect with the elasticity of close to unity. Furthermore, Ely and Robinson (1997) conducted the co-integration tests using data of stock prices and commodity prices, instead of stock returns and inflation rates, and finally found the same results as previous studies. The only difference was that the elasticity that was calculated in their analysis was less than unity.
Anari and Kolari (2001) contributed further evidences on the positive and permanent inflation hedge potential of stocks over long horizon using monthly time-series data of stock prices and goods prices from 1953 to 1998 in six chosen industrialized countries, which are United States, Canada, United Kingdom, France, Germany and Japan. However, their estimation of the long-run elasticity of stock prices with respect to goods prices is different from previous empirical studies. By utilization of co-integration test methods, results displayed that the slope coefficient was more than one unit (range from 1.04 to 1.65) across these six countries. The weakness of Anari and Kolari (2001) studies is that they cannot well explain why the abnormal above-unit coefficient is observed. This demit was improved by Paudyal and Luintel (2006). They used monthly time-series data in seven industry sectors in UK during 48 years and found same results as before. Then they focused on the study of the reasons of the above-unity elasticity and finally gave the explanation that the stock returns should exceed the inflation rate in order to compensate for tax. Consistent with Anari and Kolari (2001), Rapach (2002) provided considerable supports for the long-term Fisher Effects for stocks. He did the research in 16 industrialized countries and got the conclusion that long-run real value of stocks did not depreciate due to inflation, which implied that stocks can protect investors' real wealth over long period. Turn to Engsted and Tanggaard (2002), they focused on the long-term American and Danish stock market, and found some other interesting results. For US stocks, the long-run response of stock prices to expected inflation shock was positive but very weak at all horizons. By contrast, Danish stocks performed much better as an inflation hedge when the horizons increased. However, when it comes to the unexpected inflation, no evidence about stocks' abilities of inflation-hedge was found in both countries (Engsted and Tanggaard, 2002).
Another great contribution to this issue was made by Khazali and Pyun (2004) who investigated the long-run stocks-inflation relation in nine countries in Pacific-Basin (Australia, Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, and Thailand). They further proved the significant horizon effect, meaning negative relationships between stock returns and inflation at short-horizon, while turning out to be positive over a longer period of time. Khazali and Pyun (2004) stated that this result could be used to reconcile the conflicting empirical evidences that were observed among previous studies and ultimately validated that stocks can act as effective inflation-hedge over long horizon. This horizon-related response pattern of stock returns to inflation is crucial for investors who have long-run perspectives (Khazali and Pyun, 2004). Turn to the long-run elasticity of stocks prices to goods prices, the co-integration tests done by Khazali and Pyun (2004) displayed a greater than one pattern (1.02-1.67) in nine countries, which supported the previous results reported by Anari and Kolari (2001) and Paudyal and Luintel (2006).
Nevertheless, although most literatures have proofed the long-term Fisher effects between stock returns and inflation, there are still some deviations from this consensus. For example, Shiller and Beltratti (1992) and Rapach (2002) indicated in their work that stock returns were not significantly related to inflation shocks in the long run. Yeh and Chi (2009) reported the existence of long-term inverse co-movement between stocks prices and goods prices in some of the chosen industrialized OECD countries, which was consistent with the results of Sharpe (2002) and Boucher (2006).
Given the fact confirmed by most empirical evidences that stocks have good inflation-hedge effects at the long horizon, the next step investors should consider is choosing the optimal investment portfolio to maximize the effectiveness of the inflation-hedge. Schotman and Schweitzer (2000) said that the optimal portfolio can be a combination of various different asset categories, and each of them has their own inflation-hedge potentials. This well-diversified investment portfolio can be determined by using the Markowitz mean variance model of portfolio choice. According to this theory, the portfolio selection procedure can be separated into two steps. First stage is identifying the efficient market portfolio frontier. Followed that is choosing the optimal investment portfolio on that frontier (Bodie, 1976).
The horizon sensitivity is very important in exploring the effectiveness of stocks as an inflation-hedge. Overwhelming evidences in literatures indicate inverse stock return-inflation relationship for short horizon while positive response of stock returns to inflation over longer sample period. Inverse relationship at the short horizon implies that stocks cannot help hedging against inflation, higher inflation accompanies with a lower return on the stock market. There are fewer consensuses on what causes this inverted phenomenon. Possible explanations include the earliest money illusion hypothesis introduced by Modigliani and Cohn (1979), tax-effect hypothesis (Feldstein, 1980), proxy hypothesis (Fama, 1981) and market inefficiency concept (Boucher, 2006). On the contrary, at the long horizon, the positive relationship confirms that stock returns can act effectively as a hedge against inflation. This horizon-related response pattern of stock returns to inflation is crucial for investors who have long-run perspectives. Based on this positive long-run effect, investors can choose the optimal investment portfolio to maximize the inflation-hedge effects by applying the Markowitz mean variance model.
Nevertheless, there also appears some deviation from the mainstream findings what makes the issue more confused (Choudhry, 2001). Apart from the horizon sensitivity, some other factors may also influence the study results. For instance, Kolluri and Wahab (2007) found that although under a same length horizon, a positive relationship appeared during a high inflation regime but a different negative relation occurred in a low inflation regime. Another case in point is the differences in the relationships across different industries all at long horizon (Paudyal and Luintel, 2006). Consequently, the exploration about the ability of stocks to hedge against inflation is still ongoing. Further research can be done by combining different relevant influencing factors together and focusing on the joint-effects to the inflation-hedge effectiveness, then some new results may be discovered. This further improvement will offer more help in protecting investors' value during the inflationary period.
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