Inflation has been dominating the headlines for a few months now. With the risk of higher inflation on the way, one might wonder how to invest in such a scenario. After all, growing your hard-earned savings at a rate greater than inflation is the primary reason to be an investor.

Listen now and learn:

• What is inflation and how it impacts you
• The best investments for inflationary periods
• When a bad outcome is and isn’t the result of a poor decision

Plus, Peter answers a listener’s question about bond investing in a low-yield environment.

Episode

Outline

Inflation has been dominating the headlines for a few months now. Prior to the pandemic, most headlines were questioning whether inflation was too low. But today we are seeing the largest increases in prices in over a decade.

The future is always uncertain, but as I frequently say, it’s the long term investor’s willingness to bear uncertainty that creates the opportunity for profit. 

• Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future. 
• And as you’ll learn in this episode, simply staying invested can help investors outpace inflation over the long term.

But before we dive into data and strategies related to investing for inflation, let’s level set and explain what inflation is…

What Is Inflation?

Inflation is the rate at which a currency loses its purchasing power as prices increase over time. So, say a cup of coffee cost $1.00 twenty years ago. If the average annual inflation rate had been 2% between then and now, that same pour would now cost you $1.49. 

Inflation occurs when there is more money circulating than there are goods and services to buy. Think of what happens if you try to attend a sold-out concert or sporting event at the last minute: there is more demand for tickets than tickets available, which results in higher prices.

The most widely quoted inflation measure is the Consumer Price Index (CPI), which tracks price changes from month to month for a basket of goods and services used by the average consumer. Using this measure, inflation has averaged roughly 3% since 1914.

This consistent rise in prices is one of the reasons people are surprised by how much they need to save for retirement. Thanks to the power of compounding, inflation of 3% cuts your purchasing power of your hard-earned savings in half about every 24 years.

That all sounds bad enough, but we’ve seen even worse inflation in the past.

In the 1910s, the U.S. suffered four back-to-back years of double-digit inflation toward the end of the decade. The worst was in 1918, when prices rose by an astounding 20.4%. More recently, inflation averaged 7.6% from 1968 to 1981. Such periods of hyperinflation are what raise concerns among some investors.

After several decades of relatively stable prices, the question on some investors’ minds is whether the current economic conditions launch us into another period of inflation that runs well above the long-term average.

Will Inflation in 2021 Be a Head Fake or Something Worse?

I wrote an article a few months back that I’ll link to in the show notes that talked about investing for inflation. Now, the article was written before we saw these elevated inflation numbers, but higher inflation seemed inevitable because prices collapsed in the spring of 2020, so we knew with the economy reopening that the reported year-over-year inflation numbers for the spring and summer were going to be high.

As I wrote back in April:

“Even if inflation (as measured by CPI) rises through May at a rate consistent with 2% annual inflation, it will show a 3.2% year-over-year rise that would be the highest since 2011.”

This is the kind of data that inspires alarmist, clickbait-style headlines that read something like, “Inflation Highest Since 2011.”

Sure enough, those are exactly the type of headlines we’ve seen the past several months. Most recently, June’s CPI was up 5.4% for the year ending in June 2021, which naturally led to headlines drawing attention to it being “the largest annual increase since 2008.”

Expecting Some Inflation Is Different Than Fearing Runaway Inflation

If these headlines as well as the real-life price increases you are seeing in your everyday spending have you concerned about hyperinflation, consider that the economy is still a long way from operating at full capacity, and the thinking goes that getting fully “back to normal” would be the point at which inflation pressures could become problematic.

Inflation is a slow-moving process and the economy would have to run hot for a long time to push inflation significantly higher. We are already seeing signs of the economic momentum slowing, but if we think back to the most recent period of double-digit inflation in the late 1970s, it didn’t just happen overnight.

It took a series of events from the guns-and-butter spending of the Vietnam War and Lyndon Johnson’s Great Society program to kick things off. The Nixon administration continued to run the economy hot with wage and price controls. After that came two big oil price shocks.

But the following period of high inflation showed us that the Fed had the ability and willingness to the tools at their disposal to curb high inflation. There is no reason to think they would not do the same today.

Inflation – like many other things in financial markets – is a mix of calculus and psychology.

The psychology involved with inflation expectations is important because when people are accustomed to low inflation, it takes a lot to change those expectations. 

Now consider that we’ve had almost no volatility in inflation over the last 30 years. And since 2007, there’s been more concern about inflation being capable of reaching the Fed’s long-term inflation target of 2%. 

IMO, Workers and businesses would need to see inflation remain elevated for a prolonged period – not just a few months or quarters – before they start expecting higher wages and charge higher prices, thus setting off the self-reinforcing upward spiral.

Putting Inflation in Proper Context

So again, let’s put these recently rising inflation numbers into context, even if it means I end up repeating myself a little bit.

First, recent inflation readings are comparing prices from the spring/summer of 2020 when we were still deep in an unusual pandemic economy to spring/summer of 2021 where the economy has broadly re-opened.

Second, inflation is not all bad. In fact, it usually goes hand in hand with economic growth. 

The initial stages of the economic recovery has been stronger than expected, but many of the forces driving certain prices (and, in turn, inflation) higher are starting to wane. That’s why the market is pricing future inflation in the 2s rather than the 3s.

But even if inflation was in the 3s, that’s still not all that high. It’s certainly a far cry from hyperinflation. And some inflation is much more desirable than deflation, which would seemingly would be far worse for the economy and portfolios.

For most of the time since the Financial Crisis, policy makers have been fighting off deflationary forces and struggling to meet modest long-term inflation targets. 

And for what it’s worth, historically speaking, short bursts of high inflation have a much lower impact on purchasing power than sustained periods of high inflation. 

So markets and policymakers projecting this most recent spike in inflation to short-lived can be viewed positively, But what if the market is wrong and inflation does get out of hand and stays that way for a while?

• Depending on who you speak to, such a possibility ranges from unexpected, to possible, to a near certainty. 
• The reasons forecasts vary widely – and this is backed by pretty robust academic evidence – is that even excellent explanatory models rarely serve as effective predictive models.

For example, scientists can readily explain why earthquakes occur, but our ability to forecast times, locations and severities remains shaky at best. 

The same can be said for inflation. 

We can explain its intricacies, but accurate predictions remain as elusive as ever. There are simply too many variables: COVID-19, climate change, political action, the Federal Reserve, other central banks, consumer banks/lenders, consumers/borrowers, employers/producers, employees, investors (“the market”), sectors (such as real estate, commodities, and gold), the U.S. dollar, global currency, cryptocurrency, financial economists, the media, the world, time … and YOU. 

Each of these could throw off any predictions about the time, degree, and extent of future inflation. 

Besides, as an investor, you really only have control over the last two: You, and your time in the market. 

Because We Don’t Know, We Diversify

It stands to reason: Some investments seem to shine when inflation is on the rise. Others deliver their best results at other times. 

Because we never know exactly when inflation might rise or fall, an investor’s best course is to diversify into and across various investments that tend to respond differently under different economic conditions. 

And if you’ve not yet done so, it’s definitely time to define your financial goals and build your personalized, globally diversified portfolio to complement them. 

If you’ve already completed these steps, you should be positioned as best you can to manage higher inflation over time, which means your best next step is most likely to stay put. This brings us to our next point …

In the long-run, stocks are the best hedge against inflation. Historically, average global equities returns are nearly 7% more than the rate of inflation.

A big reason stocks handily beat inflation over time is that corporate earnings and dividends tend to grow faster than inflation. Going back to 1928, both U.S. dividends and earnings have grown roughly 5% a year while inflation has averaged about 3% a year.

It’s true that stocks have historically experienced below-average returns during periods of higher inflation, but ultimately corporations pass on higher prices (wages and input costs) to consumers, which in turn boost revenue and earnings in the long run.

It’s also important to add, no fancy market-timing moves are required or desired when participating in the stock market. 

• In fact, moving holdings in and out at seemingly opportune times is more likely to detract from the vital, inflation-busting role stocks play in your portfolio. 
• To borrow a recent quote from Nobel Laureate Eugene Fama: “The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.” 

Again, stock market returns have historically experienced below-average returns when inflation is rising, but it’s not the doom and gloom you might expect.

• I have some data from an article written by Ben Carlson, which I’ll link to in the show notes. 
• Since 1928, the average annual return for years in which the inflation rate is rising, the S&P 500 had an average annual return of 6.7%, while the average annual return when inflation is falling was nearly 17%. 
• Since 1928, the average annual inflation rate in the United States is right around 3%.
  • When inflation has been above 3%, the S&P 500 has returned an average of 6.3% compared to an average annual return of 15.7% when inflation is less than 3%.

Market expectations for inflation over the next 5 and 10 years spiked in the spring, but has since fallen back into the 2% range, which suggests that the market sees most of the price pressures easing as supply and demand imbalances throughout the economy work themselves out.

But what if higher inflation persists longer than expected?

Short Duration Bonds and Cash

While stocks are your best bet for beating inflation in the long-term, short-duration bonds (and even cash) are the best bet to combat inflation in the near- to intermediate-term.

The same article from Ben Carlson that I just mentioned outlines the performance of stocks vs short duration bonds and cash.

Short duration bonds perform well in periods of inflation because higher inflation leads to increases in interest rates. Rising rates are a good thing for bonds because you can reinvest interest and principal payments at higher rates.

And although rising rates result in immediate bond price declines, the impact is relatively muted for short-term bonds since their prices are less sensitive to interest rate fluctuations. Unlike other inflation hedges, short-duration bonds (and cash) experience far less volatility.

Treasury Inflation-Protected Securities (TIPS)

TIPS are bonds issued by the U.S. Treasury in which the principal value rises and falls with changes in the Consumer Price Index (CPI). The coupon payment on TIPS is also continually recalculated off this adjusted principal amount.

The problem with TIPS is that current expected inflation is already baked into prices and yields. That means you only win if inflation is higher than expected. Using the 10-year breakeven rate in the chart above tells us that the market expects inflation to average 2.3% over the next ten years. If average inflation over the next decade is higher than that market expectation, then a bet on TIPS will pay off. 

To me, using TIPS this way is an active bet that you are smarter than the overall bond market. And remember that the bond market is driven by massive institutional traders that collectively know more than any one person.

Perhaps a better route would be to utilize a strategy that buys short-duration corporate bonds while using CPI swaps to protect against price rises. There are funds out there that offer this type of exposure, which I find intriguing.

• Fair warning, this is a little more complicated of a topic, so I’ll spend less than a minute on it…
• CPI swaps are a type of derivative that involves paying a counterparty a sum that’s linked to current expectations for inflation in return for receiving an amount of money that depends on what inflation actually is at a given maturity. 
• This sort of strategy involves more credit risk, but it offers higher expected returns than TIPS-only strategies and allows for greater diversification.

Gold, Commodities, and Bitcoin

Tactically investing in any of these assets to hedge against inflation is a form of market timing; something we all know conclusively doesn’t work. Even so, they aren’t very good inflation hedges anyways.

Gold has been an awful inflation hedge since gold futures began trading in 1975, in part because they tend to rise in anticipation of inflation (rightly or wrongly) rather than with inflation. That explains why there isn’t a strong correlation (stat speak for the relationship between two or more variables) between gold and inflation.

Perhaps even worse is that gold is highly volatile, which makes it a poor hedge for something like inflation that is relatively stable. Extreme volatility creates similar problems for using a broad basket of commodities to hedge inflation.

Since I last wrote about Bitcoin at the end of 2017, there has been wider institutional acceptance of the digital currency, which has created a floor of sorts in terms of value.

There are several prominent theories that lay out the case for owning Bitcoin, but the closest one to an inflation hedge is that Bitcoin is a form of digital gold. But we’ve already established that gold is a lousy inflation hedge, so I’d argue the merits of using Bitcoin as an explicit inflation hedge shares the same weaknesses.

Again, hedging a very low volatility risk such as inflation with a very high volatility asset like cryptocurrency (that btw comes with a litany of non-inflation related risks) doesn’t make a lot of sense to me.

So Even With Higher Inflation, the End Goal Remains the Same

So to wrap up this conversation on inflation, I’ll share one last broad idea, and it might just be the most important one thus far….

• Prices and yields already embed the market’s expectation of inflation. So inflation concerns are really about the negative impact of unexpected inflation on the real value of your invested wealth.
• Making moves in your portfolio to outguess financial markets on the outlook for inflation is futile. You’re much better off focusing on how to outpace the harmful effects of inflation on future spending.

Nobody has a crystal ball. Fortunately, we don’t need a crystal ball to address inflation in our portfolios. The data suggest that simply staying invested helps outpace inflation over the long term.

The primary goal of investing is growing your assets at a rate greater than inflation without taking undue risk. That hasn’t changed.

If you still feel concerned and wonder what to do with your investment portfolio in the face of potential inflation, you could try a number of tactical bets. But as I’ve outlined just now, these don’t always provide the solution investors really want. It’s also worth repeating that the current data suggests the risk of runaway inflation is very low.

The best option for beating inflation remains a mix of stocks, bonds, and cash. Stocks are easily the best long-term position to hedge inflation, even if one might expect below average returns in years with above average rates of inflation, while short duration bonds and cash position have historically done well in the near-term during inflationary periods.

Listener question

As an investor who was around in the 1970s, I remember what it was like to experience red-hot inflation, but at least you could squeeze a decent yield out of a bond portfolio. 

Given the low-interest rates and growing inflation, where would you look to enhance the bond portion of your portfolio?

…

This question actually was actually submitted through a response to my email newsletter, which you can sign up for at peterlazaroff.com.

While double-digit yields may sound great, this ignores the impact of inflation. The real returns on most of those double-digit yielding CDs and Treasury Bonds people talk about had low single-digit real returns.

But there’s no avoiding it, lower interest rates have reduced expected bond returns. But bonds still have a purpose in your portfolio and that is to provide a valuable ballast for volatility in the stock portion of your portfolio.

That should always be the primary function for bonds. If you start reaching for return, it means you are taking on more risk. Risk and return are closely related, and generally you 

Even with our upward revisions, returns from bonds in most markets are likely to be modest. We nonetheless still see their primary role in a portfolio as providing diversification from riskier assets rather than generating returns.

Keep in mind that return forecasts change in response to evolving assessments of economic and market conditions, but that doesn’t mean your investment plan should change. In fact, long-term investors often have the best chance of investment success by staying the course if their investment plan is diversified across asset classes, sectors, and regions and is in line with their investment goals and tolerance for risk.

In addition, for clients concerned about the impact of shifting market conditions on their retirement portfolios, consider sharing this recent piece that explains how a dynamic spending plan can have a dampening effect on portfolio volatility.

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If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.

Until next time, to long-term investing!

About the Podcast

Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence. 

Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.

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