by Michael Evans, Founder & CEO of Cogent Strategic Wealth
In case you haven’t noticed, inflation—like that Audrey II plant from Little Shop of Horrors—seems to have taken on a life of its own lately. Initially fed by a harmless drop or two of economic blood, inflation has grown and grown, until its cries to “Feed me!” are no longer cute, thus leaving us wonder how do you protect your portfolio from inflation. No wonder “Americans Are Having an Inflation ‘Aha’ Moment,” as reported in a mid-March Wall Street Journal piece:
- “The Labor Department recently reported the February consumer price index climbed at its fastest rate since 1982.”
- Consumers are feeling the pain, and rethinking their spending on everything from gas to groceries.
- Business owners are likewise playing an unpleasant game of “budgeting Tetris,” as one online retailer described her efforts to balance prices with costs.
What Caused the Recent Inflation?
Last summer, the Federal Reserve and many economists were forecasting (or at least expressing hope) that the uptick in inflation would likely be a transitory side-effect of the stimulus we’d been feeding to an anemic economy. But as usual, nobody could have forecast the number of aggravating events that have played out since. As one Wall Street Journal market analyst observed:
“[L]ots of stories suddenly apply at once. The market’s focus on Russia’s invasion of Ukraine is being interrupted by the supply-chain effects of Covid lockdowns in Chinese technology hub Shenzhen, imminent tightening by the Federal Reserve as it tries to catch up with inflation, and the risk to the reflation story as consumer sentiment is crushed by rising prices.”
At best, these and a host of related geopolitical and socioeconomic realities are making it harder to tame inflation; at worst, they’re piling on fresh fertilizer.
Historical Context on Inflation
To envision the future, let’s check in with the past. Unless you’re at least in your 60s, you’ve probably never experienced steep inflation in your lifetime, including the years of high inflation that began in the late 1960s and peaked at a feverish 14.8% in 1980. Americans were literally marching in the streets over the price of groceries.
What happened next? During his 1979–1987 tenure, Federal Reserve chair Paul Volcker is credited with routing the runaway inflation by ratcheting up the Federal target funds rate to a peak of 20% by 1980. (Compare that to the Fed’s increase to 0.05% in mid-March 2022.) Aimed at reducing the feverish spending and lending that had become the status quo, Volcker’s strategies apparently facilitated a resolution. By 1983, inflation had dropped much closer to the cooler target rate of 2%, around which it has mostly hovered ever since. Until now.
Yet, while many of the adults who owned real estate were complaining of their 14% mortgages, I recall rejoicing at the 11% interest rate on a 1-year CD at a local bank back in 1984. Oh, the good old days.
What’s Next?
Will inflation spin out of control this time, or can we tamp it back down sooner or later? Can the Fed thread the needle by raising the target funds rate to cool down the cash flow, but without triggering a significant recession (which was another result of Volcker’s actions in the 1980s)?
Either way, what can you do as an investor to steer your portfolio through the turmoil?
“I never think of the future — it comes soon enough.” — Albert Einstein
In reality, not even the Federal Reserve has a crystal ball to predict future inflation, or unlimited power to “fix” it. Fortunately, we don’t need a crystal ball to address inflation in our investment portfolios. The data suggest that simply staying invested in a globally diversified portfolio helps outpace inflation over time. Let’s explore that body of data, as well as additional investment actions you can take to make best use of it.
Does High Inflation Lead to Low Returns?
Do you wonder whether stock returns will suffer if inflation keeps rising? Here’s some good news: High inflation isn’t necessarily bad news for stocks.
Exhibit 1 shows U.S. stock performance relative to inflation over the past three decades. Since 1992, annual returns have fluctuated widely. But weak returns sometimes occurred even when inflation was low. And even after adjusting for inflation, 23 of the past 30 years delivered positive returns.
Exhibit 1 The Real Thing: Annual inflation-adjusted returns of S&P 500 Index vs. inflation, 1992–2021
Bottom line, we see no reliable connection between periods of high (or low) inflation and falling (or rising) U.S. stock returns. Looking back even further to periods when inflation was much higher, history still shows that stocks have handily outpaced inflation over time.
Exhibit 2 The relative performance of Stocks, Bonds, Bills and Inflation (SBBI®) Series in 2020 and Over the 1926-2020 Time Horizon, Average Annual Returns
How You Protect Your Portfolio Against Inflation
Again, history shows that stocks tend to outpace inflation over the long term, which suggests today’s rising prices don’t have to foil your long-term financial goals. However, as we’re experiencing here and now, they can put a dent in your financial plans and retirement reserves.
We have no magic wand to eliminate the challenge entirely. But there are two broad approaches for addressing the risk of inflation in your portfolio. You can:
- Hedge against inflation: Hedging your assets against inflation focuses on protecting your near-term consumption against rising inflation—especially if you’re in or near retirement, when it’s more difficult to offset inflation with increased income.
- Seek to outpace inflation: Outpacing inflation is about positioning your portfolio to grow bigger and stronger over time, delivering returns that handily exceed the rate of inflation. If your goal is to fund future spending, investments that are expected to outpace inflation are more appropriate.
Depending on where you stand today, chances are you’ll need some combination of both hedging and outpacing inflation to protect your current and future consumption.
Hedging Against Inflation
Inflation-indexed securities such as Treasury Inflation-Protected Securities (TIPS) and inflation swaps are natural candidates for hedging your investments against inflation. They are inherently structured to deliver returns that rise and fall in tandem with rising/falling inflation.
What about using commodities, Real Estate Investment Trusts (REITs), value stocks, or stocks in “inflation-sensitive” industries (such as food and energy)? Some have proposed these also may be good inflation hedges.
However, consider a recent paper, “US Inflation and Global Asset Returns,” by Dimensional Fund Advisors’ Wei Dai and Mamdouh Medhat. Analyzing data from 1927–2020, Dai and Medhat suggested investors should proceed with caution when considering alternatives to inflation-indexed securities. In a separate paper, “Are Concerns About Inflation Inflated?” they further discuss their study’s results.
- Weak correlation: Among most global asset classes, they found “mostly weak correlations between nominal returns and inflation.”
- High volatility: The authors did find statistically significant positive correlations between energy stocks, commodities, and inflation. But they suggested, while such assets might contribute to outpacing inflation over the long run (which we’ll cover next), they were too volatile—20 times more volatile than inflation—to be an effective near-term inflation hedge.
The authors concluded: “If the goal is to reduce the variability of future purchasing power, it is questionable that hedging with something this volatile will effectively achieve that.”
We agree. Investors on a fixed income may be tempted to seek any immediate port in an inflationary storm. But it’s important to avoid the ones that are known to harbor misaligned risks, given the task at hand (i.e., sustaining your upcoming consumption).
Outpacing Inflation
If you are like me, we look to the financial markets as our main investment avenue. The good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has more than offset inflation.
Corporations demonstrate the ability over the long-time to pass on higher costs to the consumer through pricing power. Even better, companies seek to fight rising costs by innovating and becoming more productive. Innovation is what America does very well.
This is documented below in the growth of wealth graph, which shows monthly performance of various indices and inflation since 1926. These indices represent different areas of the US financial markets, such as stocks and bonds.
As evidence-based investors, we embrace the beneficial role of stocks in creating real wealth over time in the past.
T-bills, or cash, have barely covered inflation, while longer-term bonds have provided higher returns over inflation. US stock returns, however, have far exceeded inflation and significantly outperformed bonds.
Another key point is that not all stocks or bonds are the same. For example, consider the performance of US small cap stocks vs. large cap stocks over this time period and the cumulative difference in $1 invested in each index in 1926.
Keep in mind that there’s risk and uncertainty in the markets. Historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.
What Are Your Next Steps?
Are you worried that unchecked inflation may start taking big bites out of your portfolio? We realize the uncertainty can create a lot of angst. It may cause you to freeze in place and do nothing. Or it could spur you into rash reactions you might come to regret. Neither extreme is likely to reduce your concerns.
Again, we cannot tell you what the future has in store. But we can help you determine a Cogent course for hedging against inflation in the near term, while seeking to outpace it over time.
For more than a decade, Cogent has been advising successful professionals, high-achieving entrepreneurs, and similar highly motivated individuals and their families on how to mitigate unexpected risks in their financial plans. Let us assist you in better understanding where you are at, what may stand in the way of your getting there, and how to leverage an evidence-based investment portfolio to convert well-laid plans into decisive action.
At Cogent Strategic Wealth, we offer a fresh approach to helping you Design | Build | Protect Life on Your Terms. What would your best evidence-based investment portfolio look like? To find out, sit down with us today for a Cogent Conversation. We’ll listen to what success looks like for you, explore any challenges your family faces, suggest how to protect your portfolio from inflation, and help you build and manage that portfolio every step of the way.
Don’t manage your family’s financial future all on your own. Book your Cogent Conversation today!
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