A few weeks back I made a post called Nowhere to Run (Maybe) which dealt with where investors can find some shelter in the current inflationary environment.
A quick Google search of “where to invest with inflation” will produce a number of seemingly logical answers that have become the standard for many financial advisors as well: energy, real estate and commodities. But has anyone actually tested historical data to see if this indeed true?
A recent paper from the NBER flips this conventional wisdom on its head and offers important clues for investors on how to approach the current bout of inflation.
In this study, the authors first broke out and parsed inflation into 2 categories: core inflation, which includes things like food, goods and services and energy inflation which tends to be more limited to oil and gas. They looked at 8 different assets classes, some of which are conventionally seen as asset that are a traditional hedge against inflation. These were US stocks, treasury notes/bonds, agency bonds, corporate bonds, currencies, commodity futures, REITs and international stocks.
What they found is that things like commodities and stocks did a decent job with keeping up with energy inflation but they noted that energy inflation was not persistent. This is likely because energy prices are strongly linked to the volatile demand for energy, which is highly subject to geopolitics, economic growth and supply shocks.
More worrying, what they did find was that none of these asset classes provided any hedge against core inflation in the short term. They also found that core inflation was more persistent over time. In fact, they found that all of these asset classes were negatively correlated with core inflation, meaning as core inflation grew higher, all these assets fell in value.
Beliefs vs Reality
For investors and advisors alike, this poses a vexing problem. It also begs the question if we have experienced anything similar in the past and if there is a takeaway we can ascertain from it.
Given that we are looking at a period of sustained inflation in the US that we have not experienced in almost 40 years, many have been comparing our current times to the 1970’s. In that same light, I thought I would look at that period and across different asset classes to see if there is something current investors can takeaway from those long ago volatile times which saw persistent core inflation.
Below is data that I collected from NYU Stern which shows real returns for various asset classes for the last 100 years. I took the period from 1970 to 1982 as this was a time that saw markets falling, inflation high and volatile energy prices. Before looking at those returns in more detail, it helps to understand the context in which they took place.
The period saw a bear market and recession from 1973 to 1974 where the stock market fell almost 50%. The US was still in the midst of the Vietnam war despite Nixon’s assurances the U.S. would withdraw and the administration also officially eliminated convertibility of the dollar to gold. This saw the price of gold skyrocket in USD terms and ushered in the era of floating exchange rates between the major currencies of the world.
It also saw a double dip recession in 1980 and 1982 as Paul Volcker and the Fed raised rates to kill off inflation, ushering in a 40 year bull market in both shares and bonds. Most of us know that the 80’s and 90’s was a great time to invest but it’s also important to understand that the seeds of that bull market was born in the hard scrabble 1970’s. This was a period of political and economic angst. After dismal returns for over a decade, retail investors fled the stock market. There were 7 million fewer retail investors in 1979 than there were in 1970. Nothing says that better than the famous cover of Business Week from August 1979 that proclaims “the death of equities.”
Returning to the asset class returns, the table shows the annual inflation for each year as well as the real returns of those asset classes. Similar to the author’s findings in the NBER study, much of the decade saw all asset classes fail to keep up with inflation over time periods of 1-3 years and even some periods of 5 years and beyond, depending on when you started measuring.
Skeptics and equity bulls may point out that the cumulative annual returns for both stocks, corporate bonds and real estate were positive over the entire period examined here but many of these returns were saved by massive returns in 1982 after inflation had been killed off.
The primary takeaway from looking at this period is that no asset classes beat inflation in the short to medium term. The recession of 1973-1974 and its bear market were particularly brutal for investors. For those arguing that real estate will save investors, it’s worth noting that real estate experienced 2 bear markets during this period lasting 4 years and 3 years respectively. The only solace real estate investors can take away is that the downturns were not as brutal as those in equity or bonds.
This may help explain the counterintuitive returns that today’s investors have seen in assets that are supposed to hedge for inflation like TIPS ETF’s, fall in value. Seeking Alpha published a good explainer of why TIPS ETFs have fallen 17% this year despite being essentially shielded from inflation. In short, the article explains that those TIPS ETF’s will eventually provide good returns but those returns are a few years off as TIPS bonds mature in at least 5 years or more and only at maturity is the inflation payment realized. Investors have been selling these bonds off as they can get 3-4% annual returns now from even shorter term bonds so they prefer the payment now, even if it’s not beating current inflation.
What Will Happen if Inflation Persists
Worst of all is that the returns shown from 70’ to 82’ are hypothetical and don’t include taxes. Interest from bonds and dividends at the time were taxed at ordinary rates. This means that after tax returns for the entire decade never kept up with inflation.
Right now the market is expecting inflation to fall in the coming year. Proponents of this argument point to the inversion of the 10 year and and 3 month treasury yields as evidence. However, this is just merely a market prediction and markets don’t always predict the future accurately and markets certainly didn’t predict the last year of high inflation and higher rates. So why are economists relying so assuredly on near term predictions the market is making now?
There is even some evidence now that the rapid tightening the Fed is doing may not slow inflation as many economists predict. A number of central banks across the globe picked up on the higher inflationary environment and acted on it long before the Fed did and the results so far don’t yet support the higher rates killing inflation argument.
Brazil, Chile and Poland among others, started raising rates earlier and much more aggressively than the Fed starting in mid 2021. The Economist has dubbed these economies “Hikelandia.”
As the paper noted:
It feels a little unfair. In July 2021, as rate-setters in America and Europe dismissed the risk of entrenched inflation, the Central Bank of Chile got its act together. Worried that inflation would rise and stay high, its policymakers voted to lift rates from 0.5% to 0.75%. The bank has since raised rates again and again, outpacing investors’ expectations and taking the policy rate all the way up to 11.25%. Perhaps no other central bank has pursued price stability with such dedication.
Has the star pupil been rewarded? Hardly. In September Chile’s prices rose by 14% year on year. The central bank’s preferred measure of “core” inflation, which excludes volatile components like energy and food, jumped to 11%.
None of these economies which were aggressive on rates have been rewarded so far, as prices have continued to climb throughout all of them.
All of this should worry shorter term investors, especially those in or near retirement because it signals that we could be in for a period of more prolonged inflation than the market is predicting. There are some valid counterpoints which include inflation having a long lag time to policy changes and the deflationary momentum of working age population shrinkage in many as a aced economies which may point towards reverting to the low inflation trend we have witnessed over the past 30 years. The absence of inflation in Japan despite global inflationary levels supporting this argument.
Yet astute investors should be prepared for both scenarios and in the case of a prolonged inflationary environment, there is a high likelihood that the market could fall significantly further. To understand why we just have to go back to our same observation period visited from 1970 to 1982.
During that time, since the market was not beating inflation, investors gravitated towards where returns were more assured rather than relying on the hope that corporate profits and valuations would move higher. This led to lower multiples for the equity index and higher dividend yields. Investors like a sure bet and what better way to have a sure bet than what you are going to be paid now, ie this year’s dividend versus next year’s. This preference for the here and now as well as competition from bond yields drove equity prices continually down and the dividend yield up.
Dividend yields in the early 80’s reached as high as 6% to 7% in stark contrast to the 1.82% currently offered by the S&P 500. In fact dividends were a major contributor to total returns for the entire decade of the 70’s due to this yield.
No other decade other than the lost decade of the 2000’s, saw dividends play such an important role in returns. The current S&P 500 would have to fall by 63% in order to get to a dividend yield of 5% and that’s including the 20% drop seen year to date.
Will Vanguard and Diversification be Proven Right in the Next Decade?
If things go down this darker route, which as we’ve seen they well could, is there anything investors can do in the near term? Is there anywhere they can look for markets that may be more adequately priced for such an environment? Funny enough, as I have been touting for many years on this blog, international shares, although also elevated in price, seem to offer less downside when compared to US shares.
Currently the Vanguard FTSE All-World ex-US Index Fund (VEU) yields 4.04% and has only returned 1.98% on annual basis since 2007, essentially a zero or slightly negative return when inflation is taken into account, do this figures not sound eerily similar to US returns during the 1970’s and early 80’s?
That markets can see long periods of under performance and that further diversification improves returns without significantly increasing risk is the crux of the theory and argument that researchers and professionals have used to advise the all-in-one funds at Vanguard such as the target date retirement funds that many are invested in through their 401k default investments.
Our list of returns in the 1970’s did not in life international shares but if they did they would have shown outperformance. Looking back, it wasn’t until the 90’s that US shares sustainably outperformed international shares. Other than a brief period in the early 2000’s, US shares have been dominating since. The best opportunities come when pessimism and apathy are at their maximum and I would argue that this time is now for international shares after suffering from geopolitics and a strong dollar this year.
So the takeaways from this are not sexy but they are relevant: investors should be mentally prepared for a case in which returns are flat or even negative for extended periods of time given the potential for the inflation picture to not materialize as the market expects. They also would be wise to stick to their guns in terms of diversification and include international shares as there are valuation arguments to be made as to this sector being less prone to the downside. Time will tell who is right but as always, it pays to be hedged for either scenario.
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