(The opinions expressed here are those of the author, an

investment strategist for Panmure Liberum.)

By Joachim Klement

LONDON, April 23 (Reuters) - 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)