(The opinions expressed here are those of the author, an investment strategist for Panmure Liberum.)

LONDON - Equities are often viewed as a good inflation hedge, but history shows that real returns on U.S. stocks tend to drop quickly once inflation rates top 3%.

While Wall Street has recently ​hit record highs amid relief about the U.S.-Iran ⁠ceasefire announcement and the related decline in crude prices below $100 a barrel, that deal is proving fragile. With inflation already well above the Fed’s 2% target - and more energy-driven increases likely - investors shouldn't ‌bank on stock markets to protect them from further price increases.

The Federal Reserve's preferred inflation gauge, the U.S. personal consumption expenditures (PCE) price index, rose to 2.8% year-on-year in February, and likely rose further in March as the war boosted global oil ​prices and sent pump prices soaring above $4 per gallon for the first time in more than three years. The March data is due on April 30.

Meanwhile, consumer price index (CPI) – the inflation gauge that often drives headlines – jumped to 3.3% year-on-year ​in March. ​Even though core inflation, which excludes food and energy, only rose modestly, this offered little comfort. Economists warned that March's figures only reflected the first wave of the oil price shock, with further inflationary pressure still to come.

The Dallas Fed on April 6 estimated that headline PCE inflation could rise by 0.35 percentage points above pre-war forecasts if the Strait of Hormuz – the critical ⁠artery for the global energy system – remains closed for one quarter. If the strait remains closed for three quarters, the inflation surge could be as large as 1.47 percentage points by the end of this year, they posit.

Those scenarios have not been taken off the table, especially because even if a lasting ceasefire deal is implemented, there is no guarantee that the transit through the Strait will go back to normal anytime soon.

A FLAWED CONSENSUS

In this environment, investors are looking for inflation hedges. Gold has seemingly lost its centuries-long ability to hedge against inflation and crises - at least for now - putting other options into focus. One asset class that ​is commonly cited as a good inflation ‌hedge is equities.

The common ⁠argument for equities’ inflation-hedging abilities goes like this. ⁠Companies suffer from inflation in the form of higher input costs, but they can eventually pass these on to customers in the form of higher prices. Therefore, after an initial shock, corporate earnings should not be impacted ​too much by higher inflation.

Unfortunately, this theory ignores the experience of equity investors in times of high inflation. The relationship between S&P 500 real returns and the ‌prevailing inflation rate at the time can be easily shown using Robert Shiller’s data for the U.S. stock market since 1871. As long ⁠as inflation rates remain below 2% to 3% in the U.S., stock market real returns remain high and unaffected by inflation. But once inflation rates climb above 3%, real returns start to drop, and once they surpass 5%, they tend to fall rapidly towards zero.

The mechanics of this breakdown in returns are pretty intuitive. Higher inflation translates into a higher discount rate for future cash flows, driving a derating of stock markets that accelerates once inflation approaches 5% per year.

And if input costs rise too fast, businesses increasingly struggle to pass them on because they can’t adjust prices fast enough. Customers, squeezed themselves, also start to cut back on spending.

At this point, a spike in inflation creates lower top-line growth and slimmer profit margins, which dramatically reduces future expected cash flows. The result is a drop in share prices to accommodate this changed outlook.

DIFFERENT ORIGIN, SAME STORM

Some argue that this logic only applies to supply-driven inflation like the one we are experiencing at the moment. Still, history shows that even when inflation is primarily demand-driven, stock markets don’t deal with it well.

Adam Shapiro at the San Francisco Fed splits U.S. inflation into a supply-driven component, a demand-driven component and ambiguous components that do not fit either category.

His analysis ‌shows that the inflation shocks from the 1990s to the pandemic were mostly demand-driven and small, giving rise to the notion ⁠that stocks are a good inflation hedge.

However, the post-pandemic inflation shock resembled more the shocks of the 1970s and early 1980s, which were predominantly ​supply-driven with a smaller demand component.

When inflation is driven by strong supply shocks, stock markets see their real returns decline rapidly. But the data also shows that if demand-driven inflation becomes too high, stock returns quickly become negative. History is clear: once inflation reaches the levels now prevailing in the U.S., equities stop being a shield and start being a liability. The investors who recognise that soonest will be the ones best placed to weather what comes next.

(The ​views expressed here are those ‌of Joachim Klement, an investment strategist for Panmure Liberum.)

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(Writing by Joachim Klement Editing by Marguerita Choy)