On inflation, stocks, bonds, and cash

image from Bloomberg, Feb 23, 2018 https://www.bloomberg.com/quote/SPX:IND

Why did the market "go down" in late January, 2018?  There are many possible reasons, and most of the time a substantial move in the market is really about a combination of things (if there is any real reason at all).

My current vote for the "biggest" reason for this particular fall in the price of stocks is what was happening in the bond market, which was itself reacting to what was happening with the Federal Reserve policy, which was itself...complicated.

Inflation always matters...sometimes, it matters more

In brief, the Federal Reserve in the United States has a few main purposes, which are often reduced to the "dual mandate" of promoting employment and moderating interest rates.  The entire financial system relates more or less directly to the cost of money over time (aka interest rates), and inflation is a major consideration in how the markets set appropriate interest rates for a given investment or transaction.

Again, speaking in simple terms here, for an investment to yield an economic gain to the investor, the realized return must be greater than the rate of inflation for the same period.  If not, the investor is actually losing "purchasing power".  For example, if I have $1 today and a can of soda costs $0.50, I can buy two cans.  If I wait a few days, and the price of the soda rises to $0.55 but my $1 is still just $1, I can no longer buy two cans...the purchasing power of my dollar has eroded due to inflation.

In January of this year, two things seemed to come together to jolt the market: (1) the major US stock indices were setting records for the longest period without a "correction"; and (2) the Chairwoman of the Fed was stepping down and aside for her successor.  My view is that these two factors were causing the market to process what might happen with inflation, both from pressure of a "hot" stock market, and from the relative uncertainty as to how the new Chairman would respond to that pressure.

The US has enjoyed a very long period of relatively tame inflation, and the prospect of a quicker increase in consumer prices can be unsettling.

Investment options in an inflationary period?

For investors (which includes normal folks looking to properly manage their retirement savings), the task of how to best position themselves in a period of rising inflation can be challenging.  Here are a few points to consider:

• "Fixed income", as a category, tends to fair poorly in an inflationary cycle.  Some potential strategies:
  • Longer term bonds tend are generally worse off when inflation strikes, so it may make sense to look at the maturities and duration of the bonds in the portfolio.  In the case of bond mutual funds or ETFs, look at the segment of the bond market the fund targets to get an idea of the average maturity or duration; better yet, pull up the details of the individual holdings
  • Shorter term bonds and well structured "bond ladders" may still perform as intended in the portfolio; if rates are rising, as the short term bonds come due, it may be possible to reinvest the proceeds into higher yielding options, as appropriate
  • Certain sectors and types of bonds are especially sensitive to rising inflation and market rates; "preferred stocks", for instance, tend to exhibit high sensitivity in this type of cycle.  Similarly, "zero coupon" bonds, or STRIPS, or even regular bonds with relatively low coupons (think < 2.5% - 3% in the current market) will all take a big hit on value in a rising rates market
  • Annuity products with a fixed accrual rate, or a fixed minimum annual "return" may be especially costly when facing inflation.  These insurance products tend to come with significant expenses to hold, and don't "mature" in the way that short term bonds do.  Depending on surrender periods, the tax impacts of withdrawing, and opportunities to "exchange" into other annuity products, there may be a relatively attractive option to exit a low rate product in an inflationary cycle
  • Both the US treasury markets and the corporate bond markets now have "inflation adjusted" bond offerings; these may perform better as a hedge to hold relative value than as a place to find gains, but may play a role within a broader portfolio
• Stocks and returns in the stock market are also subject to eroded economic gains if inflation gets out of control
  • Some stocks have historically behaved as a sort of proxy for "fixed income"; utility stocks are an example that some investors hold primarily for their relatively steady stream of dividends.  The issue here is that many utility companies are not free to raise prices to match inflation, which may limit their ability to raise their dividend payment rate.
  • In recent cycles of rising rates, emerging market stocks showed sensitivity to rising rates and Fed policy; it may prove prudent to review the allocation to this sector
  • Some companies stand to benefit from rising prices, particularly in industries where the profit margins rise along with prices.  It can be useful to consider whether a sector or individual company belongs to that camp, or are in the position of being squeezed on profits when their input prices rise due to inflation.
• Over the long term, residential real estate seems to have kept pace with inflation.  However, investment products tied to the real estate markets may be complicated by holding exposures to home builders, construction supply companies, etc that draw their own value from economic activity related to real estate and not necessarily from the property values themselves.  Further, real estate related investments tend to show some sensitivity to interest rates due to the impact of higher mortgage rates on the ability or desire for people to get a home loan.
• Other assets, like gold or various commodities, exhibit complicated relationships with inflation and interest rates that are difficult to model in an actionable way when designing a portfolio
• Holding cash into an inflationary cycle may provide an opportunity for tactical allocations into investments that match the investor's goals and risk tolerances; putting "extra" cash to work after a dip in price for those investments could be advantageous.  However, holding cash for an extended period while prices are rising will definitely lead to that loss of purchasing power as described above

Time to review with a pro?

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