Perhaps the most dominant economic trend of the past 50 years has been the persistence of falling and low inflation.
In the U.S. inflation peaked in the late 1970s somewhere around 13-15% (see chart below). In an effort to combat this scourge, Paul Volcker, the then Chair of the Federal Reserve, embarked on a painful and controversial strategy of hiking the prime interest rate to a now unimaginable 21.5% (yes, twenty-one and a half percent).
The strategy was not for the meek nor without serious consequences: the U.S. economy plunged into a deep recession and certainly contributed to Jim Carter being thrown out of office in 1980. Despite this, Volcker prevailed and is now credited with "breaking inflation's back." Inflation declined precipitously in the early 1980s and remained in the extremely tame 1%-3% range for much of the subsequent 40 years.
Aside from consequences on everyday purchasing power of individuals, inflation and its relationship with interest rates have a powerful impact on financial markets.
It is no coincidence that the peaking of inflation in the early 1980s also marked the beginning of one of the longest bull markets in stocks and bonds in history. Yes, there were significant periods of volatility and bear markets during the last 40 years, but, overall, this has been an incredibly rewarding era for investors in almost any combination of stocks and bonds. Low inflation and interest rates were certainly among the key enablers.
After such a long period of mild inflation, it is only human to succumb to the tendency of assuming that future will always be like the past. The prevailing view became that inflation was never coming back. Policy makers and economists became more concerned about the prospect of deflation. Economist Roger Bootle even wrote a book titled "The Death of Inflation: Surviving and Thriving in the Zero Era" in the 1990s.
To paraphrase Mark Twain, news of inflation's death was greatly exaggerated: Fast forward to 2021 and inflation is suddenly back with a vengeance.
The reasons for this resurgence are many. Global economies are snapping back to normalcy as the pandemic winds down. Incredible amounts of fiscal stimulus have created excess amounts of cash in consumers' pockets, driving increased demand for all sorts of physical goods (houses, used cars, Starbucks guava juice, etc.). Global supply chains are still trying to recover from the pandemic leading to shortages of goods. Businesses are having a hard time attracting enough employees, leading to wage increases. Finally, the anticipation of a multi-trillion revamp of the U.S. infrastructure has led to an increase in prices for many industrial commodities.
As expected, there is no consensus about what this increase means and where inflation will go from here. Fed officials maintain that this is just a temporary blip as we transition to the post-pandemic world. They believe inflation will peak around 3% this year and then moderate thereafter. On the other hand, Deutsche Bank sounded a more alarming note a few days ago, calling inflation a "global time bomb" that may cause serious issues for consumers and investors alike.
Most recent inflation figures (released on June 10, 2021) show consumer prices continue to rise sharply (the CPI jumped 5%) and there are no signs of inflation moderating yet.
What does inflation mean for assets and investments?
Accepted wisdom is that rising inflation is perhaps worst for bonds. As interest rates rise, prices of bonds and bond funds declines. This is a dynamic we are already seeing this year, especially with long maturities bonds, which are down some -7% year to date, despite a fairly resilient stock market. Inflation is also detrimental to cash as it accelerates the loss of purchasing power. The caveat is that cash's ability to keep up with inflation depends on short-term interest rates. Should short-term rates remain near 0% as they are currently, rising inflation will erode the value of cash holdings faster.
Inflation is also viewed as broadly beneficial for stocks and they are considered an effective long-term hedge. Finally, commodities have historically benefited the most from inflation as prices of fuels, raw materials, and foodstuffs increase.
A recent research study ("The Best Strategies for Inflationary Times" by Henry Neville and co-authors) takes a deeper dive into how various asset classes do in periods of rising and high inflation. Not surprisingly, the impact of inflation on various assets and investment strategies has been a lot more nuanced.
For example, the study found that, while rising inflation is initially good for stocks, persistently high inflation is not, because high interest rates and cost of capital have a depressing impact on companies' cash flows. Consumer durables have been a particularly poor performing stock sector during inflationary periods (see table below).
Additionally, commodities don't benefit equally from inflation. Commodity that has done the best in inflationary environments is energy. Precious and other metals perform relatively well. Paradoxically, agricultural commodities tend to do relatively poorly, especially if governments intervene to limit the increase in food prices.
Real estate prices tend to rise on a nominal basis. However, real returns from real estate investments tend to hold steady in the face of inflation. In other words, real estate keeps up with inflation, but does not necessarily outpace it over the long-term.
Perhaps the most interesting and thought-provoking finding of the study is that inflationary times may favor "dynamic" or more active investment strategies, as opposed to passive strategies, which have become extremely prevalent in recent decades.
Source: Exhibit 2, The Best Strategies for Inflationary Times, https://ssrn.com/abstract=3813202
How should investors prepare for inflation?
In our view, investment portfolio construction should always be driven primarily by the unique circumstances and objectives of the portfolio owner. Furthermore, research studies like the one above should always be taken with a grain of salt. Just because energy did well in past inflationary periods is no guarantee that it will do so in the future.
History may not repeat, but it often rhymes. Therefore, it is still important to study past inflationary periods and learn from them.
If the current spike of inflation proves to be more than just transitory, we expect that cash and bonds will continue to do poorly. Stocks will likely do better, but constructing stock portfolios will require flexibility and willingness to go beyond what worked best over the last 10-20 years. Finally, after being the worst performing asset class over the last decade, commodities again deserve serious consideration due to their tendency to do well in inflationary times.