What’s the relationship between inflation, bonds and stocks?

Inflation AND THE Stock Market: Understanding the “Fed Model”: Greet Bekaert, Columbia University and NBER; and Eric Engstrom, Federal Reserve Board of Governors

What is the relation between inflation and equity returns? In the US markets, academics and market experts have often remarked on the strong correlation between nominal bond yields and the earnings yield on stocks. Earnings yields move inversely with stock prices, so that means a negative relation between stock returns and inflation. Bond yields rise with inflation expectations, but why will earnings yield rise? These are the questions that Bekaert and Engstrom try to answer in their paper.

The authors find that while 55% of the variance in the bond yield is driven by expected inflation, 80% of the variation in the earnings yield is driven by the equity risk premium. Why then should there be a correlation between the two yields? That will only happen if expected inflation, the main driver of bond yields, is correlated with the equity premium, the main driver of the earnings yield.

The authors then find that 79% of the co-movement between equity yields and bond yields comes through the equity premium. But is the correlation between expected inflation and the equity risk premium rational or is it the result of investor miscalculations brought about by inflation?

The final finding: high expected inflation coincides with periods of high risk aversion and/or economic uncertainty, which depresses stock prices and, therefore, increases stock yields. One of the reasons for this result is that there have been several episodes of stagflation in the US, which not only raises bond yields, but also depresses stock returns. This is the core of their argument: “We postulate that in recessions, economic uncertainty and risk aversion may increase leading to higher equity risk premiums, which, in turn, increase yields on stocks. If expected inflation happens to also be high in recessions, bond yields will increase through their expected inflation and, potentially, their inflation risk premium components and positive correlations emerge between equity and bond yields, and inflation”.

The authors then look at some other countries to test their findings. They arrive at the conclusion that unlike in the US, rather than the covariance between expected inflation and the equity risk premium being the main driver for the stock-bond yield covariance, the main reason is now the correlation between expected inflation and expected cash flow growth.
The authors point out, “Nevertheless, even if this is the correct interpretation of the data, stagflation remains a critical ingredient: Inflation happens to occur at times of depressed earnings expectations. Note that we use objective, not subjective, earnings forecasts, so that this cannot be caused by money illusion. “In other words, periods of inflation lead to uncertainty and risk aversion, leading to lower stock returns.

But stock and bond yields moved very differently after the 2008-09 crises. That was because the period saw a recession, but expected inflation was very low. Hence stock prices were depressed, which meant high stock yields, but bond yields slumped due to low expected inflation.

It would be interesting to look at the relationship between inflation and stock returns in India over the longer term.

At present, for instance, the market is jittery about higher inflation leading to higher interest rates and hence lower growth.

(Source - livemint)