Inflation, Rising Rates, and Investments – Historical Perspective
What Does History Tell us about the Impact of Inflation on Investment Returns?
Stocks and Inflation.
The impact of inflation on stocks is complicated. On the one hand, stocks appear to offer some hedge against inflation. It makes sense. As inflation rises, companies can increase prices to maintain their profit margins. Therefore over time, stock prices should be resilient in the face of higher prices. Over long periods of time, returns on stocks have consistently outpaced inflation. So are stocks a reliable hedge against inflation? Alas, life is not that simple.
One problem with this analysis is something I will call “demand destruction”. As inflation increases, consumers may find themselves with less disposable income, as more income is consumed by the rising cost of food, energy, and other “necessities”. So companies may be able to maintain margins by raising prices, but revenues may decline as sales revenues decline.
The other problem is interest rates. As inflation rises over a “normal” rate of 1-3%, interest rates also tend to increase. When interest rates increase, investors may find fixed income investments more attractive. Stocks need to provide a higher potential return than safer fixed income investments to compensate investors for risk. If nothing else changes, the price of stocks must come down when interest rates go up to maintain this “risk premium”.
Recession risk. Periods of inflation are often (but not always) followed by a recession. As inflation increases, the risk increases that the “economic boom” that resulted in the inflation will be followed by a “bust” (recession) as interest rates and higher prices squeeze consumer spending and business investment. Greater recession risk will depress stock prices.
From 1973 through 1984 we suffered through a long period of inflation, stagflation, and recession. Despite a severe two-year bear market at the beginning of this period, the S&P 500 returned 8.0% per year for this 12 year period. During the same period inflation ran 8.2%. So despite all the economic turmoil of this era, and two recessions, stock returns did at least keep pace with inflation. (source: Dimensional Matrix Book)
There are two stories to fixed income investments and inflation.
Early in the cycle (where we are now) interest rates will increase rapidly in an effort to tame inflation. As interest rates rise, bond prices fall. Eventually, however, interest rates stop going up. This may be because the economy has tipped into recession, thus sharply easing inflationary pressures. If this happens, it is likely that the government will need to switch to cutting rates sharply to fight the recession. This would cause bond prices to rapidly rise again.
Perhaps though, rates will stop rising because inflation has cooled off just enough to relieve the need for higher rates. In this event bond prices may simply plateau. Bond investors might not see a rapid recovery in value of their investment, but they will enjoy much higher interest yield (dividends) due to the now higher rate environment.
Either way, pain for bond investors lasts so long as interest rates are expected to keep moving higher. Once rates stop going up, bond investors can expect to see better results. Of course, no one knows how long rates will need to increase. Just this week we saw the market reset its expectations regarding higher interest rates as inflation seems to be more persistent than previously expected. Bonds suffered another round of losses as a result.
Lets again look at the period from 1976 through 1985. Long term government bonds (the most sensitive to inflation and rising interest rates) returned 5.3% through this period. This included several years of severely negative returns during the period of rapidly rising rates that occurred from 1977-1981, but also included a strong recovery in 1982-1985. Although long term government bonds might be the LAST place one would choose to invest during a period of high inflation and rising rates – the patient investor still would have earned positive returns that offset much of the inflation during this period.
Annuities, managed futures, option-based strategies, commodities, and real estate all provide returns that MAY provide some protection in times of stock and bond market stress. These are all tricky investment areas however, and one needs to tread with care.
Annuities sometimes get a bad rap (sometimes deserved) but may offer meaningful protection and diversification value. One needs to be very careful about fees and expenses – which are often hidden and not easily understood. Several companies now offer low cost “no-load”, commission free annuities which can provide attractive diversification opportunities. Annuities are complicated – and you want the advice of a fee only financial planner. (Unfortunately, most fee only advisors have little knowledge of or experience with annuities – but I do!) Don’t expect to get wholesome advice from a financial advisor who is paid commissions for selling annuity products, as the commissions are very large!
Real estate investments also have a complex relationship to inflation. Direct owned real estate offers the best inflation protection. Real estate funds (REITs, ETFs, mutual funds) on the other hand are pulled in two ways. On the one hand, property values and rents increase. On the other hand, most real estate investment companies have high levels of debt, so higher interest rates can pressure profits, while rental income may fall if recession reduces occupancy rates. Real estate funds may offer some diversification value, but it is limited.
Commodity funds can offer direct protection, as they offer a way to invest directly in the price of oil, agricultural products, etc. But again, all is not so simple. Funds that trade in price futures carry unique risks that most investors do not fully understand. This is a highly nuanced area and is subject to extremely high volatility. A less risky way to bet on rising commodity prices and inflation is to own raw materials and energy stocks (although at this point prices for these stocks have already appreciated dramatically…so it may be too late).
Managed futures and option-based strategies offer potential to limit market exposures – but from hard experience I can say one needs to be careful in this area. Stick with simple, easily understood strategies implemented by large, well-established firms employing experienced managers, and limit exposures to a modest share of your overall portfolio. If you don’t fully understand the strategy, don’t go there. Novel strategies from upstart firms promising protection against falling stock prices seem to pop out of the woodwork whenever stock market volatility increases. Most underdeliver, some fail miserably. Apply the old maxim: If it sounds too good to be true, it probably is!
It is difficult to offer any historical analysis of these alternatives for the 1973-1984 period since the indices which track them either don’t exist, or do not date back to the 1970s. The only exception is real estate. The US Dow Jones REIT index tacking real estate investment trusts dates to 1978. During the high inflation / high interest years of 1978 – 1985, the index posted a return of 26%, soundly outpacing inflation. I suspect the returns would be more stock like if we were able to look back through the recession and bear market of 1973-1975.
So What Does all This Mean for Your Retirement Plan?
Quite simply – stay invested. As always, news can be scary – but even through the worst period of stagflation, inflation, and rising rates in our nations history, investors in any of the above would have done better than an investor who remained in cash (which would have lost more than 50% of its purchasing value over this time period!) But you need to remain invested through THE ENTIRE MARKET CYCLE in order to reap the rewards!
Note: Past performance does not guarantee future results!