The following is an excerpt from the quarterly investment commentary we recently sent to clients.
It is hard to escape the inflation topic these days. The recent surge in consumer prices elevated the core inflation rate to its highest level since the last year of George H. W. Bush’s presidency. That is to say that it has been a really long time since we faced legitimate inflation.
There are two competing views on where go from here.
The first view – espoused by the Federal Reserve – is that recent inflation is “transitory” due largely to temporary supply chain bottlenecks. The sudden, V-shaped spike in demand for goods and services faced off against insufficient supply of semiconductors, flight attendants, restaurant staff, clementines, truck drivers, and lumber – among many other items. The Fed – along with many economists – makes the case that these supply chain disruptions will be resolved in the coming months as global lockdowns ease, as factories reopen to full capacity, and as temporary unemployment benefits expire bringing more workers back online. Moreover, the categories of the economy that experienced the largest uptick in inflation of late were categories that suffered the biggest deflation last spring (airlines and hotels). This suggests that recent inflation figures are simply a byproduct of pandemic-impaired industries reestablishing pre-pandemic prices.
The competing view is that many of the inflation pressures are long-term and that we could be dealing with rising prices for years, not months. The first defense of this view is that accelerated government debt issuance and ballooning budget deficit required to fund the monetary and fiscal stimulus programs will be long-term inflationary. Furthermore, some economists cite the stockpile of household savings that consumers built up during the pandemic as a key driver of demand that will enable businesses to raise prices. Adding to this argument is the view that employers will compete for limited labor as the economy reopens, forcing higher wages to attract the limited pool of employees.
So which is it? Is this inflation transitory or persistent?
The only honest and forthright answer is that we do not know. And while plenty of economists, market forecasters, and outspoken friends will confidently express their view as an indisputable reality, the truth is that all of them are likely to be lousy inflation forecasters. Historically, nobody forecasts inflation well. Not economists, not bond traders, and not consumers.
The economy is incredibly complex and, as a result, both economic activity and inflation are highly unpredictable. Austrian School Economists have made the case for two decades that increased money supply and huge budget deficits in the US would result in inflation. Such predictions – while justified in theory – have fallen flat in practice. Japan has been the most indebted developed country in the world for nearly 3 decades (debt/GDP of more than 260%) and has fought deflation – not inflation – for the past 30 years. Despite government debt in the US increasing to a level larger than our annual GDP over the past decade, inflation has remained well under 2% before the recent uptick.
It is worth noting that some of the transitory inflation pressures are already dissipating. Case-in-point: lumber prices increased by nearly 300% from the start of the pandemic through May 2021 as home renovation projects skyrocketed and supply could not keep pace. It was not necessarily a shortage of lumber – just the complications of getting trees cut, wood processed, and lumber shipped during the pandemic. Since early May 2021 – as some of the supply disruptions were addressed – lumber prices have plummeted more than 50%.
But a lot of experts are predicting that inflation is on the horizon, right?
Yes, and dart-throwing chimps have been better historically at forecasting inflation and economic growth than the most astute and experienced “experts”. In fact, robust evidence finds that the more confident a forecaster is about the future, the less likely such predictions turn out being.
The Cleveland Fed uses objective data from the bond market and futures market to estimate the market’s expected rate of inflation over the next 10-years. At the end of June, that figure was 1.58%. This is as good an estimate as any for the inflation rate over the next decade.
Is my portfolio protected against inflation?
Yes. But we have to be clear about what “protected” means. Protected does not mean we are making a binary-payout gamble where you own a few concentrated assets that profit handsomely if inflation rises (beyond what is expected) or lose dramatically if inflation falls below expectations. Protected means that your portfolio is designed to increase purchasing power (real growth, after inflation) across different inflation environments.
Although lacking glamour, the best way to achieve this inflation protection is via a diversified portfolio. No one knows how assets will respond to unexpected inflation but the stocks in your diversified portfolio should be a good long-term hedge as companies with pricing power will benefit from higher revenues as the prices of goods and services rise. Additionally, domestic inflation would likely be accompanied by a weakening dollar which benefits foreign stock investments (foreign stocks rise in US dollar terms as the dollar loses value, all else equal).
I hear about gold as a good inflation hedge. Should I buy gold?
Gold has a reputation as an inflation hedge but that reflects good – albeit misleading – marketing rather than historical evidence. Here is the empirical truth: gold is an effective inflation hedge if the measurement period is centuries. But gold has been an overwhelmingly unreliable and poor inflation hedge over more practical time periods such as months, years, and decades.
I recently listened to a CFA Society podcast where the interviewee succinctly described the ideal characteristics of an inflation hedge: it should be positively correlated with inflation, it should have relatively low volatility, and it should have a positive expected real return. Now consider how gold stacks up to those three criteria. Since gold futures began trading in 1975, there has been effectively zero correlation between gold prices and unexpected changes in inflation. The volatility of gold has been 25% higher than that of stocks. And gold does not have a positive expected real return. All told, gold has exactly zero characteristics of an ideal inflation hedge.
What about other investments like commodities or TIPS?
The evidence with commodities is very much like that of gold. They are extremely volatile and have produced negative real (after-inflation) returns since they became widely available for retail investment in the early 2000’s.
TIPS (Treasury Inflation Protected Securities) provide better characteristics as an inflation hedge because of their automatic inflation adjustments and we maintain a healthy long-term allocation to these bonds in Golden Bell portfolios. But they are far from perfect. Notably, the current expected real return of TIPS is negative such that if you buy 5-year TIPS today and hold until maturity, you lose 1.6% per year to inflation. Moreover, the price of TIPS between issuance and maturity moves based on several other factors such that they only protect against inflation if the bond term matches up perfectly with the investment horizon you are seeking to hedge.
Why own high-grade bonds right now with rising interest rates on the horizon?
To be clear, there is zero assurance of rising bond rates on the horizon. “Experts” have inaccurately forecasted rising interest rates for more than two decades running now. Moreover, no one would be buying 10-year Treasuries today at 1.3% if they knew with clarity that 10-year rates would be higher in 6, 12 or 18 months from now. Buyers would back off and yields would rise to attract buyers into to the market and reflect the expectation of higher future rates. This is how markets work. Current inflation expectations are reflected in current bond prices so avoiding bonds when inflation expectations are already high is akin to buying home insurance after a fire.
But the Federal Reserve just indicated that they are likely to hike rates twice in 2023. Don’t we want to avoid owning bonds when that happens?
Nothing gets me more discouraged for consumers and frustrated for the profession of financial advice than when I hear financial advisors suggest that high grade bonds do not deserve space in a portfolio right now because yields are low or because the Federal Reserve is going to increase rates in the future and that is going to negatively impact bond prices. Such claims are uninformed and reflect alarming confusion about how markets work.
Really, really, really important and misunderstood point: The Federal Reserve’s open market operations only directly impact the front-end of the yield curve: bank savings accounts, 6-month CDs, floating rate mortgages, etc. The Federal Reserve does not set or directly control intermediate and long-term interest rates that matter to bond prices. The Fed hikes short-term rates to starve off inflation pressures that impact longer-term rates but the collective market determines where the level of bond yields should be based on the collective expectation of future inflation. Each of the last two times that the Federal Reserve began hiking short-term rates, 10-Year Treasury yields were lower one year later.
OK, but bond yields are really low so even if interest rates don’t go up, aren’t high grade bonds still a lousy investment?
Bonds will always have a lower expected return that stocks. Less risk, lower return. Rinse. Repeat. The purpose of high grade bonds in a portfolio is insurance and protection. Always. They are in a portfolio to counter the shock of a stock market collapse, to help reduce the downside risk of a portfolio, and to help you sleep at night. None of this changes because interest rates are low or high.
Moreover, stocks and real estate and alternative investments all have lower expected returns when interest rates are lower. Investments do not live in a vacuum. I wrote more on this topic to discredit the concept that now is a bad time to own bonds.
What all this means to you…
One of the flaws of the human brain is that it causes us to think we know more than we do, to think we are better investors than everyone else, and to think we can forecast the future. Yet most times, as highlighted above, there are two sides to a coin. We should not believe everything we read or hear without understanding the other side.
Part of the role of a quality financial planner is to understand current market dynamics to help make wise investment and financial planning decisions for the long-term. Another part of the role is to help explain and decipher those market dynamics to you so that you can better make sense of things. I hope that this has helped in that respect and welcome any questions you might have about investments, finances, or your retirement plan.