What Higher Inflation Means For Your Portfolio
Posted: Jared Jameson
Recently we wrote a blog covering the signs of inflation we are currently experiencing and defining the type of inflation this could ultimately lead to. All of that is summed up here.
This WJ Notes is the Part II to the blog and is going to cover how inflation will ultimately affect the portfolio, and what we can do about it. We recommend reading the first part in order to have a better foundation for this note.
As mentioned in the blog, there are really three sources of inflation.
I argue that the inflation we are seeing today is from some mix of the first two and is likely “transitory.” The fear, however, is after those supply/demand imbalances work themselves out, the enormous debt the U.S. has accumulated will result in a longer lasting, more dangerous inflation in the form of a weakening dollar.
Rather than debate on what type of inflation we are going to have or for how long, let us just assume the next 10 years or so has “high” inflation, somewhere between 5-10% annualized. This is about on par for the high inflation years we experienced in the 70s and early 80s. We are going to ignore the extreme case of hyperinflation (which is a total collapse of the dollar) because it is extremely unlikely and there is no portfolio for this scenario (the best investment here might be canned food and ammo).
Let us start with bonds in an inflationary regime, as this is the easiest asset class to predict. Bonds carry two main risks.
The first is credit risk, or the risk that whoever you are loaning to cannot pay you back. Government bonds are considered the least risky in this regard, while lower quality corporate bonds are generally considered the riskiest.
In our high inflation scenario, the government’s ability to pay you back is not really compromised. Worse case, they could always print more money to make you whole.
With corporate bonds, it depends. Can the company you are lending to adjust their prices to keep up with inflation? There can be a lot of nuance here, but a simple example of companies handling inflation differently would be a commodity producer (oil company) vs a commodity consumer (airline). If there is inflation in energy prices, the oil producer can pass all the cost to the consumer. On the other hand, an airline’s main cost is fuel. So as the cost of fuel rises, they will have to raise the price of airline tickets. At some point the price will reach a point where people just stop flying.
The other risk to bonds is called duration, also known as interest rate risk. Bonds generally pay a fixed interest rate (hence the name fixed income) each year, and then repay your principal at the end of the term. As a bond buyer, you want an interest rate that will pay you more than the rate of inflation. If you expect inflation will be 3% over the next 10 years, you would never purchase a bond yielding 2% unless you could buy it at discount. Taking this example more broadly, if we take all bond investors’ collective inflation expectations, you end up with market interest rates (i.e., the 10-year treasury rate).
If inflation starts to pick up, investors will demand a higher yield on their bonds which will cause interest rates to rise. As interest rates rise, the price of your current bond holdings will go down as they are now less attractive. The other factor here is how long until your bond matures.
For example, if you have a 30-year, 2% bond and inflation goes to 4%, that is now an extremely unattractive bond as you are guaranteed a 2% loss after inflation every single year. The market would demand a substantial discount to purchase this bond. On the other hand, if you have a 1-year bond, you are not locked in for as long and thus will not need to offer such a big discount to sell.
In short, inflation is bad for all fixed income investments, but some are hurt more than others. Below is a table showing the “real” (meaning after inflation) returns of cash (bonds with <1 year maturity), treasury bonds, and corporate bonds by decade, along with what inflation was like during that decade. Pay special attention to the 1970s, which had the highest rate of inflation the U.S. has experienced in recent history.
How is WJ Positioned: We can adjust these two risks (duration and credit) pretty efficiently in the bond portfolio. Currently, the bonds we own are very short in duration, and will not be as affected when rates rise. We also sold the majority of our corporate bonds earlier this year, reducing our credit risk. As a result, the bond portfolio is still able to provide some yield and protection from stocks, but at a reduced risk to rising interest rates/inflation.
Stocks are always more complicated to predict than bonds. There are several factors to consider when predicting how they will perform during a period of inflation.
What were the valuations going into inflation? How will higher interest rates affect corporations ability to take on debt? Could some of the companies that exist today survive if they had to pay twice as much in interest? What types of industries could effectively raise their prices to keep up with inflation?
For example, the United States’ most famous inflationary period is the 1970s. Below is how different industry’s stocks performed during that decade.
As you can see, Energy was clearly the standout in this decade (which makes sense given the oil embargo) while healthcare lagged the most.
One of the issues with looking at history for inflation guidance is there are not many periods to reference, and many of the conclusions may not be relevant to today’s market. For example, you may have noticed the table above does not have a “tech” industry, because it did not exist back then. Today, tech is by far the largest sector in the market. Energy, conversely, is one of the smallest.
A better way to analyze stocks may be to just lump them into two baskets, value and growth stocks. Value stocks tend to be lower priced stocks in less flashy names and industries (energy, financials, utilities, etc.), while growth has higher valuations in faster growing industries (tech, healthcare, consumer discretionary, etc.).
The table below shows the annual returns of value over growth, by decade. You will notice that the best decades for value were in the periods with the highest inflation, and by a large margin.
To recap, although stocks managed to eke out a small real return in the high inflation years of the 1970s, they were obviously impacted negatively. The table below shows stock returns over inflation by decade. Aside from the 2000s (which had two recessions) the inflationary years were by far the worst for stocks.
Of course, not all stocks are created equal. There are certain industries that can better pass on the costs of inflation to its customers. A high-quality business with low amounts of debt or high profit margins should be able to ride out some rough years longer than a low-quality business. Being able to target these kinds of stocks from the rest is critical in riding out high inflation.
How is WJ Positioned: Our stock portfolios tend to lean towards value and quality stocks, which have historically outperformed during high inflation years. In addition, U.S. stocks only make up about half of the portfolio. If the inflation were isolated to a U.S. dollar problem, then other country’s stocks could offer protection.
As shown above, if we were to experience sustained high inflation, both stocks and bonds would suffer to some extent. There are, however, various alternatives that should perform well during high inflation.
Commodities are probably the best example. Inflation is literally prices going up, so it makes sense that all the basic materials that make up the products you consume (oil, steel, wheat, lumber, livestock) would go up as well.
The problem with simply buying and holding commodities is they have not had a very good return historically and are volatile. We believe a better approach to commodities is “trend following,” meaning buying those commodities which are trending higher and vice-versa.
A popular strategy that does just that is managed futures. Managed futures not only apply trend following to commodities, but stocks, bonds and currencies as well. So, if we were to get sustained inflation, we believe these types of strategies would benefit from all the trends that result.
Another popular inflation hedge is gold. It falls in the commodity bucket, but people often treat it as its own special asset. The idea is that gold has held its value as some form of money for 1000’s of years and should continue to do so regardless of what happens to fiat (government backed) currencies. Interestingly, crypto advocates think that bitcoin will serve the same purpose going forward, as the new and improved digital gold. Both camps share the same basic idea. No matter how many dollars, yen, euro, etc. are created, there will always be a fixed amount of gold/bitcoin…i.e., scarcity.
Bitcoin does not have much history, but we can look at the performance of gold since the abandonment of the gold standard in the 1970s. As you can see the highlighted portion below, gold exploded in price only to crash for two decades after. It is hard to know how much of the return in the 70s was simply the result of ending the gold standard, or if we should expect similar performance given the same inflation today.
I included an additional column for single family real estate in the table above. Real estate is right up there with gold as what many investors assume to be the best inflation hedge. The data is not very convincing however, as the last two decades have seen better home price appreciation than in the 70s. Cheap and accessible debt may be a bigger influence on home prices than inflation, so I am curious to see how home prices would react to higher mortgage rates in a period of high inflation.
Finally, any investment in which the return does not depend on the growth of the economy or interest rates could be a good hedge to inflation. A great example would be reinsurance, which receives premiums in exchange for insuring the property damage resulting from natural disasters. The frequency of these perils is not affected by inflation of course, so you would still expect a positive return from this type of investment.
How is WJ Positioned: While we do not own commodities directly, we do have commodity exposure through our managed futures funds. These types of funds would likely do well in an inflationary period. In addition, our reinsurance and longevity insurance strategies have no correlation with inflation and have a floating rate component that will adjust to changing interest rates.
Overall, we are well positioned for a period of higher inflation. Our stocks are more tilted towards the industries and styles that would likely do well in during inflation. Our bonds have a shorter duration and are better credit quality than a typical bond index. Our alternatives allocation also contains investments that are better suited for inflation.
If we see no signs of inflation, and the environment we have experienced the last several years continues, we may be giving up a small bit of return relative to our benchmark. Still on an absolute basis, clients would be making money. We are comfortable with this tradeoff for now, but of course if the environment changes, we will change with it. If you have any questions regarding inflation or how your portfolio is positioned, please give us a call.