Are stock investments a good hedge against inflation?

In my previous post, I mentioned that stocks should provide a good hedge against inflation. If you don't believe me, consider the following quote taken from "Defying Hitler: A Memoir" by Sebastian Haffner. Haffner (real name Raimund Pretzel) was a German journalist who fled Nazi Germany in 1938 and wrote a memoir in the next year, which was only published after his death in 1999 (facinating book). As you may know, Germany was characterized by a period of hyperinflation between 1921 and 1924 which destroyed the savings of many Germans. According to Haffner, this is how people dealt with this hyperinflation:

Anyone who had savings in a bank or bonds saw their value disappear overnight ... The salary of sixty-five thousand marks brought home the previous Friday was no longer sufficient to buy a pack of cigarettes on Tuesday .. What was to be done? Casting around, people found a life raft: shares. They were the only form of investment that kept pace – not all the time, and not all shares, yet on the whole they managed to keep up. So everyone dealt in shares ... Day-to-day purchases were paid for by selling shares. On wage days there was a general stampede to the banks, and share prices shot up like rockets.

Why would stocks provide a good hedge against inflation? The value of a stock is determined by the profits of the firm. Profit is the difference between revenues and costs. If there is inflation, the costs of the firm will increase, but the price of the goods sold by the firm will also increase. As a result, the profits of the firm will not be affected by inflation. At least, that's the theory. Is this also true in the real world? My colleague Jan Annaert and I checked the relation between yearly real (i.e. adjusted for inflation) stock returns on the Brussels Stock Exchange and inflation for the period 1838-2008. If stocks provide a good hedge against inflation, real stock returns should not be significantly affected by inflation. Indeed, as you can see in the first figure below, there doesn't seem to be a clear relation between real stock returns (y-axis) and inflation (x-axis), except for some years in WW1 and WW2 which were characterized by very high inflation and low stock returns (but also note 1940: very high stock returns despite high inflation).

On the other hand, the second figure below shows that real fixed returns (short-term) are clearly negatively affected by inflation. This makes sense, since a fixed interest does not change when inflation goes up (at least to the extent that inflation is unexpected: if investors expect inflation, they will demand a higher interest rate before they are willing to invest). Note that holders of investments with fixed interest will benefit when there is deflation: the interests they receive become more valuable. This (partly) explains why bond prices have gone up so much in recent years.

Another interesting feature of the figures are the many red dots with negative inflation (deflation). Modern investors are very much conditioned by the high inflation in the 1970s and early 1980s, but before WW1 deflation was quite common. But that's another story.