Focus

November 19, 2021 | 13:15

Livin’ on the Hedge: Inflation and Your Finances

Economist

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Michael Gregory , CFA

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael is part of the team responsible for forecasting and analyzing the North American economy and financial m... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Michael Gregory , CFA

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael is part of the team responsible for forecasting and analyzing the North American economy and financial m... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Feature

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.

Favour stocks in your portfolio, but choose carefully. Canadian equities have shown resilience, while dividend yield and dividend growth take on increased importance in a real total return context. Higher-growth/higher-multiple areas of the market tend to struggle as discount rates rise.
Pick companies with pricing power that are able to pass most wage and cost increases to customers. Firms that face limited competition and sell items with inelastic demand (due to a lack of close substitutes) are likely to preserve capital during periods of rising inflation. By contrast, firms with limited pricing power are often forced to absorb higher costs in earnings. Canada has many names with a rich history of dividend increases that fit the bill.

Real estate has managed to post positive returns through inflationary periods even after accounting for price gains, meaning it has offered good protection. Notably, return data don’t include the value of rent, which would increase actual realized total returns beyond those shown in Table 2. Multi-residential cap rates today, for example would add about 4 ppts to annual returns in Canada, and they are typically inflation protected, able to rise at least in line with CPI if market conditions dictate (many rent-controlled cities actually use CPI as a benchmark). That said, real estate prices could be tested given the dramatic increase in valuations during the pandemic, especially in Canada. Commercial real estate looks less inflated at this point, and should hold up reasonably well with underlying economic conditions still strong, though the office sector faces longer-term challenges from remote working.

Other hard assets have a role. Traditional inflation hedges include commodities, notably precious metals, and gold has a strong track record. While not a hard asset, some would characterize cryptocurrencies as a form of digital gold, which might make it a modern-era substitute. However, they have a limited track record as inflation hedges, and could well sell off alongside other assets if interest rates rise too much.
Buy inflation-protected notes. Treasury inflation-protected securities pay a fixed real rate of return plus a variable return tied to the prevailing inflation rate. The higher is inflation, the larger is the combined payout. A caveat here is that real interest rates are already deeply negative, with inflation-protected notes close to all-time lows. For example, 10-year TIPs are now yielding -1.15%, pointing to very weak returns if inflation instead calms in coming years.
Diversify geographically. Inflation isn’t heating up everywhere. Japan’s CPI rate, for example, was virtually zero in October. While its economy would still suffer as a global downturn slams exports, it would stand a better chance than nations with high inflation of avoiding a recession given low interest rates.
Park some funds in money markets before central banks pull the rate trigger. Though money-market returns are tiny today, they will increase when the Bank of Canada and Fed raise policy rates, expected in the second half of 2022. Moving funds into debt securities with rising payouts and short maturities, or rate-reset preferred shares, also provides flexibility to eventually lock in at higher rates when inflation and interest rates peak, or shift to equities. These lower-duration products have largely preserved capital in the past.
Keep an eye on your debt. Inflation is generally good for borrowers as it reduces the future value of debt. Loans are repaid with money that is worth less than before, and often repaid with wages that are rising faster than when the loan was issued. But rising inflation can be cold comfort for over-extended households if interest rates climb too quickly, straining service costs. For those with already stretched finances and limited wage bargaining power, the safest strategy might be to repay debt if possible, or at least avoid taking on new loans. Consolidating loans in lower-rate products is also a good option.
Lock in borrowing costs. In a rising inflation and interest rate climate, borrowers can save money and reduce default risk by choosing fixed rates. As one example for mortgages, given our base-case forecast for the Bank of Canada to raise policy rates by 150 basis points starting in mid-2022, and an earlier 100 basis-points spread between variable and fixed-rate 5-year mortgages, borrowers would have saved moderately over the five-year period by locking in. More recently, a backup in long-term rates has shifted the balance back to variable rates. Still, the best option depends on your financial situation and risk tolerance. Families in a strong financial position might opt for a variable rate, essentially betting that inflation will retreat quickly, thus warranting less monetary tightening than markets are pricing in. Even if inflation and interest rates kept rising, variable-rate borrowers would still have the option to lock in, albeit at a higher rate than today.