I’ve always said that there’s little reason to track the economy and markets closely because mindful investors don’t get too concerned about the routine gyrations of the markets. Over the long term, the primary asset classes of bonds, and particularly stocks, have a good, although not perfect, history of positive returns.
For example, despite the scary reputation of stocks, historical data going back to 1928 suggest that there’s only about a 10% chance of losing inflation-adjusted money in stocks over 10 years. And stocks have never lost inflation-adjusted money over any 18 years in history.
So, I wouldn’t blame you if you were unaware of the news about recent increases in inflation and concerns that it might hurt investors. If you need a primer on inflation, this Mindfully Investing article provides some of the basics.
Inflation on The Rise
While I still believe that hawk-eyed economy watching is for the birds, I’m nonetheless intrigued by the recent inflation surge as shown in this long-term chart from Advisor Perspectives, which also shows the yield on the 10-Year Treasury bond and Federal Funds interest Rate (the base interest rate that the Fed offers to banks).
The green shading shows the annualized inflation rate as measured by the Consumer Price Index (CPI), which most recently registered 5.4%
It’s hard to see in the graph, but the last time that inflation hit this level was during the Great Financial Crisis in 2008. Before that, you have to go back to 1990 to find a similarly high spike in inflation. And sustained inflation of this magnitude hasn’t occurred since the early 1980s. The recent inflation spike is even more remarkable considering that inflation hasn’t been this far above bond yields (blue line in the graph) and base interest rates (red line) since the mid-1970s when runaway inflation occurred.
What’s Happening?
The most obvious cause of the recent inflation spike is the recovery from the pandemic. I’ve read lots of articles and analyses picking apart exactly why the pandemic has spurred inflation. But the basic reason is the increased demand caused by consumers getting back to normal life, which has resulted in supply-chain and employment shocks that are still working their way out of the system for all sorts of goods and services. When demand is high and goods and workers are scarce, prices go up.
How Long Will It Last?
It’s always difficult to predict the future, but most economists seem to think that inflation will subside quickly, similar to what happened in 2008¹. Some inflation watchers are even making the case that the peak has already passed. This makes sense because businesses have strong profit incentives to quickly solve the supply chain and employment problems to meet demand. The most pessimistic expectations are that inflation above 2% could persist into 2023. On the other hand, if businesses offer higher salaries to attract workers and consumers start to expect higher prices, those effects could sustain high inflation for a while longer.
Should Investors Care?
From a long-term (decades) perspective, we’ve already seen why stock and bond investors probably shouldn’t worry greatly about short-term variations in inflation. On the other hand, several years of lingering high inflation could have noticeable repercussions for investors.
Consider that inflation is relevant to investing in at least two important ways:
- Economic conditions associated with high inflation can depress nominal asset returns.
- Increased inflation reduces the spending power of your invested money, which is the key reason people refer to “inflation-adjusted” returns.
Let’s take a closer look at each of these issues.
Nominal Asset Returns
I’ve previously explored the relationship between inflation and trends in asset returns. Although the data are very noisy, it turns out that most asset classes have a negative or weakly sporadic correlation with inflation. In other words, when inflation rises, the nominal returns of most assets tend to decrease or barely increase. The asset with the best track record for “hedging” against inflation appears to be gold, although I’ve seen articles that debate this point².
I recently posted my annual update of return expectations for various types of stocks and bonds. Almost everyone is predicting stock and bond returns over the next 10 to 15 years that are substantially lower than historical averages. Most of these predictions assume long-term inflation rates in the 2.0 to 2.5% range. But if the current inflation rate above 5% drags on for several years, most of these return predictions will need to be eventually revised further downward.
Lest you become too alarmed, let’s reconsider that data noise. Look at this example of average nominal U.S. stock returns as compared to different percentiles of historical inflation.
On an average basis, the nominal returns of stocks have held up pretty well over a wide range of inflation rates. Except for the extreme deflation situation (“Low 5%” bar on the far left), the average annual nominal return for stocks has been in the range of 7% to 13% regardless of the prevailing inflation rate. Even when inflation averaged more than 17% (far right), stocks returned a nominal 11% on average. Put another way, average stock returns within each of these periods haven’t strayed too far from the all-time average annualized nominal return for U.S. stocks of about 9% to 10%.
It turns out that nominal stock returns are quite resilient in the face of inflation, even though the two measures typically exhibit a mild negative correlation. And despite the reputation of bonds as a poor inflation hedge, several researchers have found that, in nominal terms, bond returns are even a little less negatively correlated with inflation than stocks.
Of course, the caveat to this caveat is that these statistics are all averages. For example, within each of the inflation regimes represented by the bars in the above stock graph, there were particular cases where stocks performed much worse (and much better) than the overall averages.
Inflation-Adjusted Returns
Even if the nominal returns of most asset classes won’t necessarily plummet with increased inflation, investors could still lose ground on an “inflation-adjusted” basis. Let’s consider stocks and bonds separately.
Stocks – Look again at the far-right bar in the above graph when inflation averaged greater than 17%. Yes, stocks went up by a nominal 11% on average. But on an inflation-adjusted basis, those stock returns represent an average loss of -6%.³ It’s pretty impossible to save for retirement (or anything else) when you’re losing spending power to the tune of 6% per year!
We’re currently nowhere close to 17% inflation. But let’s say inflation for all of 2021 ends up at 5% and U.S. stocks end up at around their long-term average nominal return of about 10% for the year. Here’s the impact on your inflation-adjusted stock returns as compared to the 2% inflation that prevailed before the pandemic:
- 10% nominal return – 2% inflation = 8% inflation-adjusted return.
- 10% nominal return – 5% inflation = 5% inflation-adjusted return.
Under these assumptions, your inflation-adjusted stock return for 2021 decreased by nearly 40% because it decreased from eight to five percent. And this scenario can come true even without a huge stock market crash taking place.
Bonds – If you find that stock example troubling, the situation for bonds is comparatively hair-raising. First, we’ve already seen that current inflation at 5.4% is well above the 10-Year T-Bond yield at 1.65%. Second, consider that the best predictor of a bond’s total return comes from its yield as shown in this graph from Research Affiliates.
So, if you buy a 10-Year T-Bond or fund today, you can expect about a 1.65% nominal annualized return over the next 10 years.
We can use the same inflation-adjusted math as before to compare the effects of current 5% inflation to 2% pre-pandemic inflation.
- 1.65% nominal bond return – 2% inflation = -0.35% inflation-adjusted return.
- 1.65% nominal bond return – 5% inflation = -3.35% inflation-adjusted return.
But the news for bond investors gets even worse. You may have noticed that the above graph compares the starting bond yield to the entire duration of the bond, which is 10 years in this case. However, increases and decreases in bond prices can have a strong effect on total bond returns within shorter periods. For example, so far this year the total nominal return on the iShares 7-10 Year Treasury Bond Exchange Traded Fund (ETF) is -4.38% because bond prices have decreased somewhat over the year. If we apply the same inflation-adjusted math again, we get:
- -4.38% nominal bond fund return – 2% inflation = -6.38% inflation-adjusted return.
- -4.83% nominal bond fund return – 5% inflation = -9.83% inflation-adjusted return.
So, investors in a 10-year bond fund may be cruising for something like a -10% (or possibly greater) loss on an inflation-adjusted basis for 2021.
And here’s one more bit of bad bond news. Notice how the graph at the top of this post shows that inflation and 10-Year T-Bond yields tend to go up and down together over broad periods. That’s because when inflation rises, the Fed usually counters with higher base interest rates, which usually suppresses inflation. And higher base rates support rising bond yields and decreasing bond prices. So, the above math for 5% inflation is by no means the worst-case short-term scenario for bond returns.
But bond investors shouldn’t completely freak out. Let’s return to a more mindful focus on the long-term (a decade or more). Here is a graph that I adapted from Cullen Roche, which examines a theoretical situation of investing in a 7-year bond fund when interest rates rise one percent per year for many years. Although I can imagine some even worse scenarios, Roche understandably calls this a “worst-case” situation for the bond investor.
With steadily rising interest rates, the bond fund suffers negative nominal returns from price declines in the first 4 years. However, in the ensuing years, the returns increasingly recover due to the progressively higher yield being generated.
This example shows that in a rising interest rate environment a bond investor would avoid long-term negative nominal returns. However, the average annual return over the 13 years shown here is still only 2.8% nominal4. And if we assume that bond yields stay slightly above the inflation rate (as the history in the graph at the top of this post suggests), the average annual rate of inflation over these same 13 years would be about 6%. In other words, the bond investor would have an inflation-adjusted return of about -3.2% annual. That’s not a total disaster, but when compounded over more than a decade, the bond investor would still lose substantial spending power.
Conclusions
Continued inflation at the current levels doesn’t necessarily spell a complete disaster for stock or bond investors. However, it would involve substantial headwinds for these two assets (and likely quite a few others) both in nominal and inflation-adjusted terms.
On the other hand, a scenario like a stock market crash combined with prolonged high inflation is entirely plausible and would feel pretty disastrous. And in such a scenario, because of the negative effects that rising inflation and interest rates have on bond returns, Treasury bonds wouldn’t necessarily act as a great “safe haven” as people often assume.
However, it’s in trying times like these that the long-term focus of mindful investing is the most useful. A short-term-focused investor might read all this and decide it’s time to “sell everything”. But of course, that would be the worst thing to do, because low or zero-yielding cash is the one asset almost guaranteed to lose inflation-adjusted money over the long term.
From a more mindful perspective, it makes the most sense to continue to invest in a moderately diversified set of low-cost stock index funds. That’s because history has shown that the relatively high long-term returns of stocks have the best chance of staying ahead of long-term inflation. By the same token, mindful investors don’t have much use for relatively low-return bonds in any economic environment for reasons I’ve detailed before.
When it comes to the topic of inflation, I can’t seem to write a short post. So, in my next post, I hope to look at the additional issue of how rising inflation impacts saving for retirement and withdrawal rates during retirement. I’ll also want to explore some of the issues surrounding the slippery concept of cost-of-living. We’ll see how that all pans out.
1 – You may have seen some recent headlines that higher inflation is not “transitory”. But if you dig into the details, this debate is about whether high inflation will last through the end of the year or for another year or so. No one seems yet willing to predict that high inflation will continue for many years.
2 – This again highlights that the data are noisy. I’ve seen several examples where researchers’ conclusions vary at least in part due to relatively small differences in the data sets that were used.
3- Throughout this post, I’m using a rough estimate of inflation-adjusted returns, which is calculated as: annual nominal return minus annual inflation equals inflation-adjusted return. You can learn about the more precise formula for calculating inflation-adjusted returns in this post.
4 – Note that Roche assumes a starting yield of 2%, which was reasonable when he first presented this calculation. But the current yield for 7-year T-Bonds is now substantially lower at around 1.5%. I haven’t done the exact calculations, but that means for a bond investor starting today, the expected long-term average annualized nominal return for this example would likely be closer to 2.3% or about -3.7% after inflation.
