Alexi Savov & Itamar Drechsler on Investing in a High Inflation Environment

Video & Timestamps

On Thursday, March 10, Alexi Savov and Itamar Drechsler joined Markus’ Academy for a lecture on Investing in a High Inflation Environment. Savov is an Associate Professor of Finance at New York University’s Stern School of Business.  Drechsler is the Ervin Miller-Arthur M. Freedman Professor, Professor of Finance and Co-Director of the Rodney L. White Center for Financial Research at the University of Pennsylvania, Wharton.

Watch the full presentation below. You can also watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

Timestamps:

[0:00] Introductory Remarks

[8:33] Asset and Inflation Theory 101

[18:22] Why did stocks struggle during the Great Inflation?

[27:12] Regulation Q

[33:07] Credit Crunches and Stagflation

[44:39] Credit Crunches and the Stock Market

[48:20] Fears for now and future?

[49:36] The Fed, Inflation, and the Fed Put

Executive Summary

• [0:00] Introductory Remarks: Inflation was already high, and the war in Ukraine adds another element to the situation. Inflation can be viewed as a tax on precautionary savings, which pushes people into risky real investments. However, inflation is also a tax on the poor, those who cannot escape and hold real assets efficiently. What is an efficient inflation hedge that protects wealth against inflation. It can be in the form of stocks, real estate, or other currencies. Inflation Indexed Bonds like TIPS are only an imperfect hedge since one is still exposed to interest rate risk.

• [8:33] Theory shows that different assets respond differently to inflation. Nominal bonds decrease in value with high inflation, while stock prices and real estate should theoretically be inflation neutral. Stock prices are the present value of future cash flows, so for inflation to affect the stock prices, it must affect the real cash flows or the real discount rate. However, stocks did very poorly during the “Great Inflation” from 1965-1982, so many people believe stocks are negatively impacted by inflation. Bonds (unsurprisingly) did very poorly during great inflation as well, but real estate performed well.

• [18:22] Why did stocks struggle during the Great Inflation? This was a stagflationary period, which meant that firms’ profits decreased, so there were lower real cash flows and stock prices fell. Arguably, Regulation Q was a big part of this, because it capped bank deposit rates at about 5%, so there were large deposit outflows when rates rose, leading to credit crunches. Once deposits start flowing in, GDP rebounds sharply, because they are strongly correlated. Additionally, the forced deleveraging meant there was a higher real discount rate, resulting in a credit crunch and stock price decline. There were large supply shortages during this period, and oil shocks occurred during this time. 

• [48:20] Could we see something similar occur now or in the near future? This seems unlikely, given that underlying economic growth has been strong; there is no sign of a credit crunch, though further supply shocks are a key risk, especially associated with the war in Ukraine. Compared to this stage of the Great Inflation, stocks have done much better.

• [49:36] The Fed, Inflation, and the Fed Put. The “Fed Put” is the idea that the Fed will cut rates when the stock market falls. This means that the Fed induces a negative correlation between stocks and bonds, because lower stock prices mean lower rates, thus bond prices drop. This has led to some investing strategies like 60/40 stock/bond portfolio, to protect against this having a major negative effect. Fed Put appears when inflation concerns are low, because when inflation concerns are high, the Fed prioritizes fighting inflation. This means that stocks have become riskier as inflation rises. Before the Great Inflation, stock and bond returns were generally uncorrelated, but had a positive and increasing correlation when inflation rose. During Covid, because of the inflation fighting, stock-bond correlation has risen, and so they have become worse hedges as Fed Put decreases.