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Pesky inflation

2022-06-18, Michael Thompson

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Pesky inflation

The consumer price index in May was 8.6% higher than May 2021, another surprise on the high side. Examples of price hikes over the last 12 months, according to a US Bureau of labor statics report, include

  • 34.6% increase in energy prices (48.7% for gasoline),
  • 11.9% increase in food prices,
  • 12.6% increase for new vehicles,
  • 16.1% increase for used vehicles, and
  • a 37.8% increase in airfares.

The Fed reacted by raising interest rates 0.75% on Wednesday, 50% larger than initially signaled. In this article, we’ll briefly discuss what this means and what (if anything) you might do about it.

The expected Vs the unexpected

Make sure you distinguish between expected and unexpected inflation. Expected inflation is already high and priced into financial assets, including stocks and bonds. Shifting your investments based on expected inflation probably doesn’t make sense. For example, buying inflation-protected bonds now is not necessarily desirable. Other bonds have already priced in higher expected inflation and even some risk of unexpected inflation. Hence, inflation-protected bonds will only outperform if inflation rises significantly higher than the consensus expectation. This could happen, but it’s far from a reliable bet.

Likewise with stocks. Stocks of growth companies, expecting profits further out in the future, have already dropped more than companies with better short-term potential. This is because the market has adjusted to a higher level of inflation and interest rates, which makes those future profits worth less relative to short-term profits. Unexpectedly high inflation or interest rates may further boost value stocks relative to growth stocks, but again this would need to be more inflation than the consensus has already bet on.

Inflation and Investments

Historically speaking, investments have not performed well in periods of high inflation. The key is to look at real returns, not nominal returns. A nominal return on an investment just measures the gain in dollars. By itself, this is not meaningful—the goal of investing is to fund future expenditures. If you buy an asset for $100 and sell it for $200 you achieve a 100% nominal return. However, if prices of goods/services inflated 100% when you owned the asset, you gained no purchasing power—your real return was 0%.

Real returns from equities have historically been well below average in periods of high inflation. For example, from 1966 to 1982 the S&P 500 achieved a 6.8% annual nominal return. That looks OK until you realize that inflation was also about 6.8% annually, so the average S&P 500 investor gained no spending power over 16 years (a 0% real return). Incidentally, value stocks did earn a real return as their stock prices were less penalized by unexpectedly high inflation.

High inflation and interest rates devalue future earnings, and hence decrease equity values. The value of a stock is the present value of future expected earnings of that share of the business. A million dollars next year is worth less than a million dollars now, and even more so with high inflation and interest rates. Hence, growth stocks, whose earnings are further out in the future, can be particularly hard hit when interest rates and inflation increase.

As inflation drives up interest rates, bond returns increase as well. This is good for bond buyers, but bad for holders of older bonds with lower interest rates.

Historically gold has been a good inflation hedge over hundreds of years, but not dozens of years as desirable for most of us. In the article Beyond CPI: Gold as a strategic inflation hedge it’s pointed out that, post 1970, annual gold returns have only a weak correlation with inflation. In these short time frames gold is susceptible to huge declines with or without inflation. I’ve always limited my gold holdings to less than 5% of my portfolio.

Many articles have claimed Bitcoin is an inflation hedge. Its short history indicates the opposite. In the last year—the highest inflation in Bitcoin's history—the price of a Bitcoin has fallen from about 36k to 18k USD at the time of this writing. Just in the last couple weeks, in which the May inflation surprised to the upside, it’s fallen from about 30k to 18k USD. So far at least, it seems that rising interest rates suck more money out of the crypto sector than any other.

Commodities have historically done well in inflationary periods (particularly energy-related ones). However, they also have high volatility. Holders risk losing substantial money if they need to sell in a downturn. For this reason, holding some commodities may be reasonable, but a high concentration in commodities is typically not recommended.

Why are interest rates rising?

One of the Fed’s main goals is to keep inflation around 2%, and they adjust interest rates to help achieve this. This is to protect citizens—unpredictable inflation prevents people and businesses from planning future purchases. For example, how do you save and plan for retirement if your expenses may increase by huge amounts?

Reacting to inflation with higher interest rates is the Fed’s default policy. Higher interest rates increase the cost of borrowing and hence reduce demand for many items. This is obvious in the case of purchasing a house with a mortgage, but it impacts other goods/services (e.g. by discouraging credit card debt). Meanwhile, higher interest rates reward savers—your savings account and treasury bonds will pay you more to save. This dual effect of penalizing spending and rewarding saving can eventually lower prices, but often the effect is delayed.

Unfortunately, raising interest rates too much can lead to high unemployment and recession. If people aren’t buying things, employers can’t pay people to make things. The Fed has to be careful not to go too far with rate increases.

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