The problem of inflation

Essentially, bonds (and cash) yields go up and down with inflation. This is because nobody wants to put their money in a “safe” investment just to find out they lost money in real terms at the end of the process. As discussed in Article 6.2, rising inflation usually causes higher bond yields but lowers bond prices. The cumulative effect is that bond returns suffer during inflation increases. However, even in this situation bonds almost always provide a positive return (if held for their duration) because bond yields and inflation rise together.

Sudden decreases in inflation usually cause the opposite reaction, where bond yields decline and prices increase. Declining inflation more clearly favors bonds as prices increase on bonds that have favorable current yields. This is the process that drove the great bond bull market from the 1980s to present.

This is not to say that bonds are a perfect hedge against rapid changes in inflation. There are certainly shorter historical periods where bonds did very poorly. But as this graph from Article 8.3 again illustrates, bonds have usually been a safe (albeit unspectacular) investment over huge ranges of inflation conditions and fluctuations.

The problem of inflation

And as I pointed out in Article 8.3, if you hold bonds for their duration, history indicates that you’ll rarely lose significant real value over time.

Cash – The story of cash and inflation is similar, but not exactly the same as the bond story. I established in Article 7.3 that cash should be a short-term investment. This is because, regardless of whether you factor in inflation or not, cash generally provides a poor return. Cash interest rates will move up and down with inflation as shown above. So, over the short-term, it’s rare that you will have huge real losses in an interest-bearing cash account or short-term CD due to inflation changes.

For example, if inflation rises rapidly this year and your low-interest 6-month CD matures, you can usually plow that money back into another 6-month CD offering a higher interest rate. Regardless, over longer periods, you will get better returns from bonds and stocks. But there are times, like right now, where cash is nearly as good as bonds, and can be used just as effectively as bonds for the short-term ballast portion of your portfolio (as discussed more in Articles 7.3 and 8.3).

Bonds, cash, and true inflation risk – This information on bonds and cash gives us new insight into how to manage the true risk related to inflation, which is rapid and unexpected changes in inflation rates. For example, if inflation did suddenly and unexpectedly flare up next year, our mindful conclusions about using cash instead of bonds for short-term ballast would likely be entirely different in that environment. For example, as shown in the graph at the start of this “bonds and cash” section, investing in a constant maturity 10-year T-bond fund in 1982 (if such a thing existed then), would have been a phenomenally good idea.

That’s because the 10-year T-bond yield levitated 2% to 8%(!) above the rate of inflation for 20 years until about 2005. That’s why I said in Articles 7.3 and 8.4, that investing in intermediate bonds probably doesn’t make sense until the bond yield is about 2% above the inflation rate.

I also discussed in Article 8.3 that Treasury Inflation Protected Securities (TIPS) bonds are likely to provide a particularly good hedge against the true risk of unexpected inflation rate increases. TIPS provide this inflation protection by adjusting the principal and interest rates of a regular U.S. Treasury bond by the annual inflation rate, measured by the Consumer Price Index (CPI). TIPS will typically outperform similar duration Treasury bonds when inflation is positive, and under-perform T-bonds during deflation.

Stocks – Unlike bonds and cash, stock returns are not clearly correlated with inflation, as shown in this graph I created using changes in the Consumer Price Index (CPI) and nominal S&P 500 returns from Robert Shiller’s data.

the problem with inflation

Importantly, stocks provided positive nominal returns in many times when inflation was both positive and negative, even strongly so. This tells us that stocks can do well in times of inflation and deflation, but the primary risk we are concerned with are sudden changes in inflation rates. So, I broke these data down even further and examined just stock returns in the same years when inflation rates changed more than 4% (either up or down).

the problem with inflation

And given that stock reactions may not be instantaneous with inflation changes, I looked at the next year’s stock returns as well.

the problem with inflation

Mindful investing for routine inflation

For routine ongoing inflation, a mindful perspective takes us back to the simple determination that you want to invest in assets that provide returns beyond the expected rate of inflation. As shown in the above table, stocks are currently the only one of the three major asset classes (stocks, bonds, and cash) expected to have significant positive real returns. Thus, a stock heavy portfolio appears prudent for most investors right now. This is another way of expressing the same mindful conclusion we reached in the Article 7 series. This conclusion remains true considering the other risks associated with stocks, which I defined in prior articles as not routine volatility, but the relatively moderate risks of permanent losses over a long-term investing time frame.

This graph of S&P 500 nominal return data minus the CPI inflation rate (the virtual definition of real returns) illustrates this conclusion. That is, nominal stock returns tend to outpace inflation in most years, although there are certainly lots of exceptions.

The problem with inflation

We can further confirm the conclusion of “stocks over bonds” for investing in most inflation periods by looking at the real returns of long-term treasury bonds versus the total U.S. stock market starting at the unprecedented and long-lived bond bull market starting in 1982. This graph from Portfolio Visualizer presents the comparison with stocks shown in blue and bonds shown in red.

The problem with inflation

At many points in this very unusual period (like 1988, 1996, 2003, and 2013) long-term bonds would have proven to be just as good a choice as stocks. But put another way, this also means that stocks were just as good as bonds even under almost ideal conditions for bonds. And as longer-term graphs show (such as the one all the way at the start of this article), at most times, stocks have handily out-performed bonds over wide ranges of inflation conditions and rates of fluctuation.

Conclusions

We’ve determined that:

  • Inflation is a persistent aspect of the modern economy and investing environment.
    Inflation does not preferentially impact one investment type over another.
  • To obtain “real” returns our investments must exceed the rate of inflation.
  • Right now, stocks are the only investment type likely to substantially exceed the rate of inflation on a consistent basis.
  • It’s generally not helpful to think of routine inflation as an investing “risk”. Instead we can plan for and adapt to this persistent part of the investing environment.
  • The true “risk” associated with inflation is sudden and unexpected changes in inflation rates (up or down).
  • Bonds provide a reasonable hedge against inflation changes if held for their duration. Because rising rate environments provide a drag on standard bond returns, TIPS bonds are a particularly good option to hedge against unexpected inflation increases.
  • Held for the short-term, cash provides no practical hedge against inflation changes, but it doesn’t necessarily result in substantial real losses.
  • Stock returns and inflation changes are historically uncorrelated. Stocks often have positive returns during rapid inflation changes and provide a substantial, although sporadic, hedge against these changes.
  • Stocks have also historically performed better than bonds during most periods of routine inflation and kept pace with bonds during ideal bond environments.
  • Our mindful examination of inflation validates the conclusions from previous articles that in most cases, stocks are the best option to deal with routine inflation as well as the more infrequent true risk of rapid unexpected changes in inflation.
  • Having a portion of your portfolio in intermediate TIPs may provide an extra hedge against the risk of rapid inflation increases, exactly because such increases are currently unexpected.
  • Finally, cash can be a valid substitute for bonds as portfolio ballast, but only if held for relatively short periods. Inflation and interest rate changes should be closely monitored by the individual investor now and always. Such rate changes will likely require a re-evaluation of the asset allocation in your portfolio. For example, if inflation and interest rates increase rapidly soon, it may be prudent to add more bonds to your portfolio or replace cash ballast with intermediate term bonds.

This article was republished with permission from Mindfully Investing.