Markets were rattled today with the Nasdaq falling 2.11% and the S&P 500 falling 1.24% as bond yields rose and the fear of a broad correction took hold for some. Although the hashtag #stockmarketcrash was tending on Twitter, this is far from a crash. Although the Nasdaq has fallen about 10% from its peak, its still up 90% from this same time last year, the S&P 500 is still up nearly 72% from that same period.
The broad sell off is partly being driven by higher yields in bond markets. The 10 year treasury note, the benchmark rate for long term rates, has jumped from under 1% a year ago to 1.56% today. This has pushed up the price of debt of everything from corporate borrowing costs to mortgages. There are basically 2 narratives that are developing around this rise in yields and which one is the correct one has a big impact for how investors approach the market going forward.
Interpreting the Jump
One interpretation is that this is part of a natural cycle that most recoveries experience. As investors shift from safety to taking risk, they sell off their safe treasury investments and rotate into riskier assets like high yield bonds and stocks. This will naturally push the price of bonds down and hence the yields up as the two move in opposite directions.
In this scenario, inflation expectations remain subdued and cyclical stocks such as energy, industrials and financials become attractive. Energy and financial stocks have been some of the best performers so far this year as they lagged the tech driven rally of last year and catch up as oil prices and long term rates start to return to more normal levels.
Investors who believe this scenario will broadly ignore the recent sell off and see it as a buying opportunity in some sectors, playing on the continued economic recovery. They may see the tech sell off as more driven by price fundamentals as opposed to something more sinister going on with the economy or with broader expectations. Big tech names like Microsoft and Apple are still trading at trailing P/E ratios above 30, which doesn’t bode well for price growth in the coming years unless they churn out even bigger earnings in the coming years.
The other narrative is a darker one which is driven by inflation fears. This narrative is rooted in the Fed’s new policy for inflation targeting which was announced last year. The Fed has long had an implicit policy of targeting a 2% inflation rate for the overall economy. This figure is driven by research that says that large developed economies need a low level of inflation to more smoothly grow as money demand increases. I have always thought 2% was an arbitrary figure for this, it could be 2.5% or 1.5% but the economic consensus in the rich world settled on this figure a number of years ago so it stuck.
Markets knew that if inflation started to seem as if it was moving beyond that 2% figure that the Fed would be forced to raise rates to act and inflation would be beaten back down to stay within the desired range. Last year however, the Fed announced that it was relaxing its conservative view on inflation and instead was willing to endure periods of inflation above the 2% marker in order to bring the average trend to 2% rather than making 2% a fixed goal. In fact, the 2% average was always the goal but the wording that the Fed put on it around that willingness to support periods of inflation that were above 2% is what surprised many the most.
The doomsayers that came out of this announcement think that this is a recipe for inflation that will run amok. They think once the inflation genie is out of the bottle it will be impossible to put back in and the Fed will be hesitant to raise rates high enough to clamp it back down because that would require tanking the economy to do so. Investors who subscribe to this logic think there is a real chance that the US could return to a 1970’s inflation type scenario with a weaker economy. In essence, they don’t believe the Fed when it says it can push inflation back down if it starts to move above the 2% line.
I don’t believe there is an elevated inflation risk in the near term. When the lockdowns were announced last year and the economy was shuttered, we essentially were looking at the possibility of deflation as opposed to inflation. Inflation was 0.62% in 2020, far off the 2% target and as inflation starts to normalize in 2021, we will be comparing prices to a low 2020 base which will make price increases look higher by comparison. This will be the case much through the rest of 2021. Yet the question of whether the Fed can then control inflation once it is above its target is a valid one and investors who strongly believe in this scenario would have a very different looking investment portfolio compared to those who don’t.
Back to the 70’s
A low inflation scenario with slowly rising rates and a stable economy is something more familiar to today’s investors. A scenario like this may look more like the early 2000’s where tech was richly valued, inflation remained low, some bubbles developed but things generally moved along and investors moved into riskier assets such as emerging markets. An investor who subscribes to this scenario may stay invested in the broad indexes and may allocate more to foreign shares as the potential $1.9 stimulus package increases import buying and pushes down the dollar.
Yet if you believe inflation will get out of control, the Fed will be forced to raise rates and the economy could become sluggish or suffer as a result, your portfolio will look very different. The decade of the 1970’s was famous for stagflation, meaning that it was a period of high inflation and high unemployment and investors in both bonds and stocks during that period got clobbered.
The peak of inflation in the 1970’s was above 10%. Unemployment was around 8% with underemployment, those who wanted a full time job but couldn’t find one, at around 20%.
Bond investors were destroyed by this market. Bond investors who purchased a 10 year treasury note in 1970 saw it only grow 5.5% by 1979, way below the rate of inflation which rose by 103%. Stock investors didn’t fare better. The Dow started the decade at 809 and ended the decade 839. Investors in this market lost about 50% of their investment in an inflation basis, the figure is similar for bond investors. So what investments did do well?
Stagflation Defense
In essence real assets were the winners over this decade. Gold returned 10x your investment, silver 15x. Farmland has returned about 6.1% annually over the past 50 years according to the USDA and of cash rents are included this jumps to 11.5%. Three are 2 REITs that specialize in farmland that can capture this: Farmland Partners (NYSE: FPI) Gladstone Land Corporation (NASDAQ: LAND).
Countries that export commodities could also see a boom if this scenario were to take place. Not only will the value of their exports increase but their currencies should also appreciate as investors flood in to take advantage of the opportunities. This was the case during the last commodities super cycle of the early 2000’s which ended in 2007. Investors poured into countries like South Africa, Brazil and Chile while China set itself apart by being the consumer of many of these raw materials at the same time. With reasonable valuations in emerging markets and many still depending on those raw materials for much of their public equity markets, these could continue to be attractive in the coming years. Since the MSCI Emerging Markets Index is now dominated by China (around 40% is China now) iShares offers an Merging Markets ex China that has risen about 80% since last year on the back of this type of commodities play.
If the ups and downs of foreign equity turns you off, then foreign bonds in both USD as well as foreign currency denominated bonds could be attractive in this environment. PIMCO manages its PIMCO Global Bond Unhedged (PIGLX) which can capture this segment of the market.
In addition, despite the narrative that the 70’s was a lost decade for stocks, there were plenty of blue chip stocks right here in the US that performed well. Widening the scope which saw a 16 year bear market peak to trough from 1966 to 1982, the S&P 500 fell by 62.4% in real terms during that time while inflation ran up over 200% during the period.
However a few blue chip names saw great gains:
- Colgate-Palmolive returned 10.9% annually from January 1st, 1966 through December 31st, 1981.
- Wells Fargo returned 8.9% annually from January 1st, 1966 through December 31st, 1981.
- Johnson & Johnson returned 8.0% annually from January 1st, 1966 through December 31st, 1981.
- American Express returned 8.9% annually from January 1st, 1966 through December 31st, 1981.
- Pepsi returned 13.7% annually from January 1st, 1966 through December 31st, 1981.
- Exxon returned 14.0% annually from January 1st, 1966 through December 31st, 1981.
- Chevron returned 15.4% annually from January 1st, 1966 through December 31st, 1981.
- Clorox would have returned 13.5% annually from January 1st, 1966 through December 31st, 1981.
The takeaway from this is that real assets coupled with quality healthcare and consumer staple companies are able to pass on their costs to consumers, largely side stepping inflation and bear markets. Even technology could offer a haven in such an environment. chipmaker Intel surged 1,200% during the 1970’s.
So to summarize, higher inflation, if you believe it’s here to stay could seriously disrupt the economy. There is a way to position your investments that will involve real assets, foreign assets, foreign bonds and quality consumer staples companies with a case for tech companies. Those who are bold can make a one way bet, those who like to hedge can take positions betting on high and low inflation, the choice is up to each investor.
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