November 19, 2021 | 09:00
Livin’ on the Hedge: Inflation and Your Finances
The inflation and interest rate landscapes are shifting dramatically, with persistent strength in the former and upside risk mounting for the latter. While much of the attention was on the blowout 6.2% y/y reading on U.S. headline inflation in October, possibly more telling was that core CPI inflation rose to 4.6%, the strongest since 1991. Canadian inflation also matched a 30-year high in the month. Mid- to short-term bond yields have also moved higher as central bank tightening looms large. The Federal Reserve has begun to taper asset purchases, setting up rate hikes in the second half of next year. The Bank of Canada has wound down its QE program with an eye on rate hikes around the middle of next year, if not sooner. We continue to believe that inflation will be more persistent than most initially thought, and that interest rate hikes could come sooner, unfold faster and possibly result in a level that is somewhat higher than most have assumed. For investors, it’s worth dusting off the old inflationary playbook and giving it a closer look.
Chart 1 shows the evolution of U.S. core inflation since the late 1950s, while Tables 1 and 2 report average real returns of various asset classes over that period, broken down into different price environments as follows:
Price stability (46% of the time): This is the goal of central banks, where core inflation runs near the target range—we use 1.5%-to-3% in this exercise. The vast majority of the past two decades was characterized by this goldilocks environment, which was of great benefit to most asset classes. Not too hot to weigh on bonds, while not cold enough to reflect weak economic and earnings growth. Equities, Treasuries and real estate have all posted solid real returns through these periods.
Deflation risk (6% of the time): The only environment historically that Treasuries have outperformed equities on a sustained basis is when inflation falls below 1.5%, and is decelerating. We experienced this briefly in the early-1960s and early-2000s, and then most infamously during the financial crisis. Note that the nature of the latter episode and the small sample results in very weak average returns for U.S. real estate and equities.
Reflation (2% of the time): Deflation risk subsides and inflation accelerates back toward target. This has proved to be the most favourable environment for equities, with total real returns in both Canada and the U.S. pushing well into double digits. Major bull markets in the 1960s and post-2010 account for most of the strength, for this very small sample.
Inflation (23% of the time): This is what we’re really focused on now, as price growth moves above 3% y/y and is accelerating. Historically, this is not a good time for financial assets in general, but there are some relative safe spots—it’s important to emphasize again here that we’re looking at real returns (i.e., after removing inflation; so, naturally, the nominal returns have a bigger hurdle rate during times of inflation). Treasuries are the clear loser in an inflationary environment. This typically comes as central banks tighten monetary policy, long-term interest rates rise and price increases erode the value of interest payments.
On the flip side, equities have been able to scratch out more neutral real returns, acting as an insulator against upward price pressure. The TSX has outperformed somewhat in inflationary environments, as one would expect given a higher concentration in sectors like energy and materials (including gold), and a relatively low concentration of growth-oriented names that would see valuations cut deeper in such an environment. And, the value of dividends becomes increasingly important in protecting total returns. For example, the TSX index value alone has eroded at more than 1% annualized on average through these periods, but the total return has netted a positive return after inflation. Real estate also typically holds its value well.
Disinflation (23% of the time): After inflation peaks, most asset classes tend to perform well and post solidly positive real returns. Interest rates are typically falling at this point, and equity valuations are often moving higher again, helping to juice returns. The bull market that set off in the early-1980s is a classic, if not extreme, example of this.
Inflation, but why?
One caveat is that aggregating inflation-era returns masks the factors behind many different episodes through history. For example, the 1970s was characterized by an extreme negative supply shock in oil that rippled through the economy and consumer prices. Double-digit unemployment and inflation marked true ‘stagflation’, the worst combination for most asset markets. Importantly, today’s environment does not look at all like stagflation. While most of the focus is on supply-side constraints, the reality is that demand is extremely robust, job markets are tight and the unemployment rate is falling. That certainly is a ‘less-bad’ inflationary environment than some past episodes like the 1970s. Rather, periods like post-WWII rebuilding or the 1960s (social and war-time spending along with low unemployment, low interest rates and new technology) are closer parallels. In all cases, inflationary outbursts are ultimately quashed by tighter monetary policy, and this time shouldn’t be any different. In fact, the further central banks fall behind the curve, the more acute the impact of tightening might be.
What to do about it
Historically, real assets tend to outperform cash, and even some financial assets can top cash in nominal terms, even if they struggle in real terms. Keep in mind again that the returns shown are after inflation, so even weak-looking equity or real estate returns are much stronger in nominal terms. Also, it's notable that asset prices broadly have already had a tremendous run to this point.