Inflation, interest rates, Putin and your portfolio
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Inflation, interest rates, Putin and your portfolio
No one can predict how long inflation will persist, when or how much interest rates will rise, or whether matters in Ukraine will get better or worse. The financial media can’t predict these things either, although they seem to think they can with their parade of so called “experts” prognosticating and obsessing over how the market will react.
We know we can’t predict the future either, but we can look at the past to gain some insights into what is probable.
Inflation
We will start with inflation. In our post from May 17, 2021, “How do I protect my portfolio against inflation?” we noted, “Inflation readings are likely to get worse over the coming year.” That was an easy expectation to have because the harshness of the COVID shutdown set the stage for a strong economic rebound, which usually increases inflation.
Our portfolio advice was to stick with a broadly diversified portfolio which aligns with your plans. We pointed out that assets like inflation-linked bonds, which tend to move in the same direction as inflation in the short term, don’t typically earn enough to stay ahead of inflation. And assets that do tend to stay ahead of inflation over time do not necessarily track along with inflation rates. Even if you knew exactly what the inflation rate would be in a given period, it is far from clear which assets will do well.
Even if you knew exactly what the inflation rate would be in a given period, it is far from clear which assets will do well.
There is no asset class that can be relied upon to move with inflation AND beat inflation over the short-term. If you were to bet which asset class – the S&P 500 Index, Treasury Inflation Protected Securities (TIPS), or gold – had the strongest correlation between monthly returns and changes in the Consumer Price Index, you would probably bet on TIPS. You would be correct, but the correlation has been a mere .259[1]. A statistician would tell you that means TIPS do not track inflation.
You can see this lack of correlation in asset returns. Despite inflation increasing since that May post to levels not seen for 40 years, a May 17, 2021 purchase in TIP (the largest exchange traded fund holding Treasury Inflation Protected Securities) had returned just 4% by Feb 28, 2022[2], lagging inflation.
You have probably seen TV ads touting gold as great protection against inflation. The ads talk about deficits, high interest rates, high inflation and a collapse in the dollar. The ads then end with how great gold did during the inflation riddled ‘70s and tout it as a haven from geopolitical turmoil.
If the connection between those factors and the price of gold were that simple and strong, gold should have done very very well from May 17, 2021 to Feb 28, 2022. Inflation was high and going higher, interest rates rose, and Russia invaded Ukraine. Instead, the spot price of gold barely budged 2%[3]. After the high transaction costs that come with gold transactions, you would be showing a loss if you bought the pitch. Sure, TIPS or gold could take off in the future but so far the returns have been far from strong given inflation. Gold was $1,944 an ounce on the first trading day of 2021 and lost value over calendar year 2021.
The only sensible asset class that has reliably beaten inflation is stocks – and the longer the time frame, the better the record. But as you know, stocks are quite volatile in the short-term. Fortunately, during the short-term period since May 17, 2021 and February 28, 2022, the total return of the S&P 500 index provided a solid total return over 7%[4].
Maybe inflation will persist, maybe not. What we know is the global marketplace does not appear to think it will last a long time. The world could be wrong but for now, based on bond prices tracked by the St. Louis Federal Reserve, the expectation is that inflation will average 2.54% over the next ten years. Despite recent events, that’s exactly what the market expected on May 17th. Remember this when some pundit says inflation will get out of control – the rest of the world is betting real money that it will not.
Higher interest rates
What will slow inflation? Two things typically slow inflation. First is what we, the average American consumers, typically do. When prices rise by a significant amount, we change our behavior and buy less of the things that cost more. As businesses feel the effect of lower sales volume, price increases slow, stop, or reverse.
The second factor is interest rates. Rates tend to rise as inflation picks up. The Federal Reserve intends to raise rates in 2022. By raising rates, the cost of borrowing goes up, which slows economic activity. Fed rate increases are what ended the inflation of the 1970s.
However, the Fed only controls the shortest-term rates. Other rates change based on the marketplace. In fact, rates have already risen without Federal Reserve action. Going back to May 17, 2021 again, a U.S. Treasury security maturing in one year paid .06% in interest, a 5-yr paid .84% and a 10-yr paid 1.64%. As of Feb. 28, 2022, those numbers are 1.01%, 1.71%, and 1.83% respectively[5].
As usual, the media is full of negativity about the effect of higher rates on your portfolio, with claims that rising rates will kill bonds and stocks. History shows that is not exactly true.
We have good examples of this from past posts. For example, “Interest rates up, bonds down, now what?” was written in response to predictions of “bond market Armageddon” back in 2013 and “How will rising interest rates affect your investments,“ has some charts that illustrate very clearly the difference between short and long term bond values when rates rise.
“Bond market Armageddon” never materialized for our clients. Our clients avoided carnage because our clients are invested in high quality bonds of appropriate maturities, not long-term bonds which can dramatically decline when interest rates rise. Our clients’ bonds can drop in value some but by design, those drops are expected to be modest and temporary.
We believe stocks should always be expected to be volatile regardless of interest rate changes because they have shown volatility in rising, in falling, and in stable interest rate environments. Drops can happen at any time, and they are often dramatic. The market has dropped at some point in every year. Drops have ranged from -3% to -49% and there have been 14 intra-year drops of at least 10%, often called “corrections” since 2000. We’ve already had a correction to start 2022. Still, the market has shown its resilience and had a negative calendar year return in only four of those years.[6]
Stocks have usually gained during periods of rising rates, even after sharp increases by the Fed.
Stocks have usually gained during periods of rising rates, even after sharp increases by the Fed. In fact, according to researcher Nir Kaissar of Unison Advisors, the data shows the Fed has embarked on 13 rate-raising campaigns since 1954. The S&P 500 Index moved higher during 11 of them, with a median gain of 14%, excluding dividends[7]. This is yet another example of why no one should be making big bets about the direction of stocks in the short term anyway.
Putin
The invasion of the Ukraine by Russia is distressing and troubling. But we can see by looking at the markets that the world doesn’t seem to think catastrophe is coming at this point.
Looking back, it is clear most geopolitical crises turn out to be far less than catastrophic to major stock markets even if they are very disconcerting at the time. For instance, a recent review by LPL Research identified 22 major geopolitical events starting with the attack on Pearl Harbor and ending with the U.S. pulling out of Afghanistan last year. In between were events like North Korea’s invasion of South Korea, the Cuban Missile Crisis, the Tet Offensive, Iraq’s invasion of Kuwait, 9-11, and Russia’s takeover of Crimea in 2014. The reactions of the U.S. stock market varies widely but the average amount of time to recover was just 43 days and the longest recovery time of the 22 cases was after Pearl Harbor. That recovery took just 10 months.
Geo-political risk is minimized via diversification. Our clients’ portfolios have almost no direct exposure to Russian or Ukrainian markets. None of what has been happening lately should cause a prudent long-term investor to make short-term predictions and become a trader or speculator.
None of what has been happening lately should cause a prudent long-term investor to make short-term predictions and become a trader or speculator.
Our client portfolios survived the bursting of the tech bubble, the real estate bubble, the financial crisis of 2008, Covid and everything else that has come along. An increase in inflation and higher interest rates are unlikely to be as bad as any of those events – if the markets behave badly at all. Your portfolio is so well diversified that how long it takes for inflation to ease, how high interest rates or gas prices might go, what happens in the Ukraine, or what any politician or government may do can all affect markets in the short-term but shouldn’t matter with respect to you reaching your long-term goals.
So much is out of our control. But focusing on what we can control has paid off in crisis after crisis. As with other unusual times, we believe remaining diversified, disciplined, and patient is a sound course of action and being resilient is again preferred over attempts to be nimble. Invest, don’t speculate.
[1] DFA Returns [2] Yahoo Finance [3] ibid [4] ibid [5] U.S. Department of the Treasury [6] Dimensional tracking Russell 3000 Index [7] “Stocks Don't Rise Or Fall Because Of Interest Rates” Bloomberg
