If Inflation, Then What?

First, I am not a financial advisor, I hold no licenses, you should never even start to consider taking finance advice from me, I have no idea what I am talking about… you have been warned.

The question: If higher levels of inflation are inevitable, and with it come increasing interest rates, then where are the acceptable investment opportunities?

For the past several months I have been searching and scouting around for the answer.

(And although I have been formulating these ideas presented below over the past few months, this recent Twitter thread by Tavi Costa sparked the inspiration for writing them all down and provided some of the key charts. An additional thread by Lyn Alden dives even deeper into these basic underlying thoughts.)

As quick as possible, let’s take a look at the two primary variables I think are the key to investment performance over the next 2–10 years: Inflation and Interest rates. These are the key drivers of the underlying performance of all financial markets.

Interest Rate Assumption: They will go up.

For the last 40 years we have been almost in a constant state of rate reductions, this means that nearly every year the cost of money, the cost of an investment, the cost of taking a longer term risk in any financial activity has been reduced. Year over year for four decades.

When the pandemic hit, the Federal Reserve went to work and pushed rates even lower, well past what most expected even possible. World-wide rates got so low Warren Buffett raised €1 billion at 0% interest. Literal free money! Although rates have bounced off of the very bottom, the cost of money is still lower then it has been for all of human history. Under this thesis presented here a key assumption is that interest rates will continue to rise off their recent bounce, at least back to more “normal” levels of 3–5%.

Inflation Assumption: It will go up.

One reason I believe interest rates will need to increase is due to inflationary pressures. As inflation heats up, the Federal Reserve is prone to increase rates, to slow down the flow of money (as higher rates encourages savings, and reduces spending). So why do I believe inflation will heat up?

  1. The massive expansion of the money supply over the last 12-months, which I expect will continue at a more rapid than normal pace through a continued increase in government spending.
  2. A return to a more normal economy will increase the velocity of money — the number of time each dollar changes hands.

You cannot have inflation with a decrease in velocity, that is why we have seen relatively low inflation over the last year, even with an increase in money supply. But once the huge glut of newly minted money begins to move more frequently, inflation should heat up.

The Data:

Money supply: 25% of every dollar in existence today was created in 2020, a huge departure from the norm.

Velocity of Money: However the pace at which each dollar switches hands fell off precipitously. This due the pandemic, lockdowns, and that the large waterfall of new dollars are still seeking productive uses.

Under this thesis a key assumption is that the velocity of money will bounce back to more normal levels and government spending through an infrastructure bill, student loan relief, and, potentially, another round of stimulus will occur. These factors together will increase inflation, forcing interest rates to rise modestly.

Taken together that would mean we would find ourselves in a period of increased inflation — something that has not occurred in over 40 years. While at the same time experiencing increasing interest rates — something that has not occurred in over 40 years. This will leave many in a financial environment they have never experienced personally, being an active participant in financial markets, or professionally advising clients, as anyone who was a financial advisor the last time we were in such an environment has likely retired.

As I have read more and more about the likely scenario as outlined above, I have asked —

“Well where the hell do you put your money in a time like this?”

Cash? Not great — sitting on a large pile of cash while inflation is running hot will mean you are watching yourself become, relatively, more poor over time. For example, over a 10-year period of 5–8% inflation, $100 in cash would have it’s purchasing power reduced to $43–$60. One decade later, half of your wealth would be inflated away.

Bonds? Potentially worse than cash — the value of a bond decreases when rates go up. For example, the interest rate on a 10-year U.S. Treasury Bond has increased from 1% to 1.7% interest between January 1, 2021 and March 31, 2021. During that same time, the cash value of a bond investment has decreased 4.5%. $100 invested in bonds just 3 months ago would be worth $96 today, and I expect this trend to continue. Further, the cash/face value of dollars invested into bonds would decrease as much as 10–20% over the next decade due to rates increase and that cash behind that value would be losing purchasing power due to the same inflation mentioned above.

Stocks? The performance of the most widely held stocks and stock funds will again be a potentially troubling area. Generally when we talk about “stocks” we are speaking of companies that will be reflected in the Dow Jones Index, S&P 500 Index, Nasdaq Index (for technology related stocks), or the Russell 2000 Index (made of of smaller and usually growth companies ). These type of stocks could face pressure in inflationary, rate increasing environments. Growth stocks in particular will face the most pressure, as they are usually fueled by more debt, which becomes more expensive as rates increase, pushing down financial performance of the business. The Dow Jones would likely perform the best of these major indexes.

The above chart highlights the performance of the Dow Jones during the last two periods of extended and heightened inflation. As can be seen, they mostly sputtered. If this would occur again, the outcome would be close to the cash summary above. If you bought and held a stock for $100 and 10 years later that stock still traded for $100, but inflation was 5–8% per year, your real return over the decade would be a 50% loss since that $100 could only buy you half of the goods and services it could a decade before.

Not so hot.

Gold and Silver? A few months ago I was sure this was the right answer. Gold is a store of value, right? If there is high inflation, gold and silver prices should go up! Unfortunately it seems like that is not the case. As can be seen in the chart below, most clearly around the start of 2009 and in middle 2013, periods during which interest rates increased, the price of gold dropped.

Commodities? This is where I think there may be greater potential. Commodities are known to perform well in times of higher inflation, and right now, relative to stocks, commodities are at a historic low point - even after a large run up in commodity performance in recent months. The chart below shows that total value of stocks (reflected in the S&P 500) in relation to a commodity index. It has never been lower, signaling that commodity prices will likely outperform stocks moving forward.

All of these factors together, historically under priced, inflation creeping up and likely to continue, and rates creeping up and likely to continue, make this an attractive asset class. I believe this will likely remain the case for the next several years.

This is not to say that placing 100%, or even a majority of a portfolio into commodities would be a sound decision. But over the last 30+ years any financial advisor would probably be nuts to even suggest commodities as a part of your portfolio. Commodities are known to pretty volatile and higher risk. But that is with rates decreasing and low inflation. Again, if rates continue upward, and inflation increases, this is when this strategy flourishes when compared to cash, stocks (Dow, S&P Russell), and bonds.

The Risk. The downside risk, deflation. Higher interest rates can reduce spending and increase saving, this pulls money out of the economy, further reducing velocity of money. This would potentially lead to a “correction” in commodity prices seen over the last year. However, I feel strongly that the reopening surge plus the increase government spending, and need for more dollars to be created because of this spending, will outpace the deflationary forces from any increase in savings.

Commodity Based Investment Options. What then, does this look like? If I, as an investor, have considered all factors, spoken to a professional if I so wish, and have decided that I would like some exposure in my portfolio, how would I go about doing that? Below is a list of funds and ETFs which give you exposure to the commodity space. You can see many of these have had a very good year, as have broader stock indexes, but based on the data provided above, signals point to a stronger future performance in commodities than other investment options.

Although, as noted above, Gold and Silver seem to underperform during periods of rate increases, precious metals do make up a portion of almost every broad commodity index, so I have included some options here. Although these are less attractive to me than some of the other options. Metal miners still are having great years even with the recent decreases in gold and silver prices.

I have also added Financials to this list, as they are outside of the scope of commodities, but also tend to perform better in a raising rate environment.

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