Zaks Investment Advisory Service

Inflation and its effects on Bonds and Stocks; Price Elasticity of Demand

Let’s start, briefly, with the markets. Last week the markets continued to suffer through hot and cold flashes, but ended up closing the week at almost the same spot where they began. I said in our last program that in my opinion, we are slowly starting to climb out of our financial crisis. And it seems that, by all appearance, this really is happening. Out of the week’s notable developments, two almost simultaneous statements should be pointed one: one made at an economic forum by Ben Bernanke, and another made to the press by President Bush. Both tried to have a calming effect on their respective audiences – one, mostly, on the market, the other – on the American homeowner. Nevertheless, the same motif was sounded in both: do not expect the government to get actively involved in the markets’ work. Bernanke first tried to calm down investors, saying that the Federal Reserve was carefully following financial market developments, and would intervene should events warrant. But then he stated the following: “It is not the responsibility of the Federal Reserve, nor would it be appropriate, to protect lenders and investors from the consequences of their financial decisions." This is one of the chief principles of the Federal Reserve, and Bernanke reaffirmed it once again. Bush meanwhile, after announcing a few small programs for assisting the poorer homeowners, said: "The government's got a role to play. But it is limited. A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who can get through this difficult time with a little flexibility from their lenders or little help from their government." In other words, despite sentiments from many in Congress that government should step in and help the American homeowner, President Bush believes that the government’s role must be limited and that most people will have to dig themselves out of problems they made for themselves. Government intervention will simply lead to another artificial boom, and besides, most of the assistance will end up at not with the people for which it was intended, but with the financial intermediaries. It looks like the market reacted positively to both speeches, and ended the day Friday with a gain.

But now let us return to things that we started discussing at the end of one of our previous programs (this was nearly one month ago, before the financial markets were hit by storm). We said that in a time of high inflation, it makes better sense to buy stocks rather than bonds. Why it does not make sense to buy bonds is fairly evident: bond coupons are fixed. Investors will be earning the same nominal amount, which will be losing a part of its value with inflation. We are living in a time of low inflation, and thanks to people who have been heading the Federal Reserve, ones like Paul Volker, Alan Greenspan and now Ben Bernanke, inflation has been low for the past 20 plus years. But one should keep in mind that in 1980, inflation had nearly reached an annual rate of 15 percent.

So why do stocks turn out to be a better investment when inflation is high? It would seem that dividend payments and any other future returns would also lose a part of their value. Which, of course, is true. But in contrast to coupons, these payments are not fixed. They could grow. The fact is that stocks, as we know, represent a part of a company’s net worth that belongs to investors. When inflation grows, companies usually raise the prices of their products. Of course, the company’s expenses grow as well: wages and input costs increase. Nevertheless, many companies manage to preserve a balance between earnings and expenses. And so stocks turn out tolerating inflation better. But not all companies can afford to raise their production prices with equal ease. This depends on how “elastic” the demand for their goods is. I will explain what we mean by elasticity.

Some goods have an interesting characteristic: even if their prices grow, their demand remains almost as high. Perhaps the most famous example is cigarettes. Cigarette prices have multiplied in recent years. And still, even though the number of smokers has dropped, it has done so by very little. Cigarettes are an inelastic product. Some drugs behave in exactly the same manner: people buy them paying almost no attention to their price. On the other hand, demand falls sharply for other goods should their price go up. Most of the food items belong to this category: if a certain firm raises the price of, say, popcorn, many consumer will simply switch to other producers’ popcorn. If all popcorn producers increase their prices, many consumers will switch to potato chips. Popcorn is an example of a product whose demand is elastic in relation to price. The price elasticity of demand may change in the course of a product’s history. For example, a certain drug may be inelastic after its release on the market: everyone buys it no matter the price. Then, when competitors release similar products, the drug’s elasticity grows. And toward the end of its life cycle, once the patent on the drug expires and unpatented versions of the same drug reach the market, its elasticity grows even more. For example, if Schering Plough raised its price on Claritin, an antihistamine, its volume of sales would drop sharply because it has unpatented (and cheaper) alternatives.

We will have to talk about the effect price elasticity of demand has on stock prices during inflation, and on inflation’s effect on the economy as a whole, in our next program. But we now have to draw our program to a close. This was Sergey Zaks. Thank you for your attention and until next time.