Inflation and Equity Returns

Jeffrey Oxman

Inflation is a ubiquitous feature of the modern industrial economy, and there fore we all need to protect our wealth from changes in price levels.

Since Irving Fisher (1930) published his “theory of interest”, investors have viewed equities as a sound vehicle for protection from inflation. However, empirical evidence collected since the late 1970s (which will be detailed in this chapter) shows that this may not be the case: in the short run, stock returns do not adjust for inflation. That means that an increase in inflation is not accompanied by a similar increase in stock returns. However, that is not the only part of the story. In the long run, there is evidence that returns on stocks will partly compensate for inflation. It is also possible to make tactical shifts into industries that do better during inflationary periods.

In this chapter, we review the theory and evidence behind the relationship between inflation and stock returns. To set the stage, Table 13.1 shows the average (over the period 1995–2010) equity returns (nominal and real) and inflation rates for 23 of the world’s largest economies. Real equity returns are in general positive, although four countries