Inflation Dos and Don'ts

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Hi, it's Jack Howe, and this is the Barron's StreetWise Podcast, listener question edition. It's my way of saying I took off for Thanksgiving week, but I've lovingly baked up a short episode answering one of your questions. It's about inflation. In a moment, we'll discuss where it's headed, what to do about it, and what not to do, and we'll hear from a top investment strategist. Listening in is our audio producer Jackson. Hi, Jackson.

Hey, Jack.

Have you prepared some listener questions, special theme music, and for the sake of podcast margins, Did you keep it royalty-free?

Yeah, it's definitely royalty-free.

Hit me. Hey, hey, pop the hand, pop the hand, pop the hand, pop the hand, pop the hand. I mean, it's high energy. It's maybe a little clubby. We can keep looking around there, Dance Machine. Meanwhile, who are we going to hear from?

Yeah, we have Adam in South Korea.

Hey, Jack and Jackson. My name's Adam. I'm coming from Seoul, South Korea, and I have a question about this temporary versus permanent inflation debate that's happening in the news right now. And relative to my stock portfolio, I was born in '92 and I started investing about 11 years ago, so I've never seen bond yields greater than nearly zero in real terms. And at some point the Fed must raise these rates if the inflation persists. So when does that transition happen when I might consider adding allocation to bonds Or am I insulated from inflation to a certain degree by owning blue chip stocks? Appreciate your help and your advice on the topic.

Thank you, Adam. Inflation is a general rise in the prices of goods and services, or if you like, a decline in the purchasing power of money. A little bit of inflation, say 2% a year, is normal, but higher levels can be painful. In the U.S., the most commonly cited inflation measure is the Consumer Price Index, or CPI. It's based on monthly price readings for tens of thousands of items. The latest CPI report shows that the inflation rate was 6.2% for the year ended October. That's the fastest rate we've seen since 2 years before you were born, Adam. The job of controlling inflation falls to America's central bank, called the Federal Reserve. It uses a different inflation measure called the core PCE, or personal consumption expenditures index, which has some different component weightings and more importantly leaves off food and energy, which can be volatile. Over long time periods, the two inflation measures tend to move together, but in the short run they can give different readings. The latest reading on the Fed's preferred inflation measure is is 4.1%. Even so, that's well above its stated target of 2% inflation on average. Now, one way the Fed can cool inflation is to raise interest rates. It hasn't done that yet because it views the causes of this inflation burst as temporary or transient, related in part to supply chain disruptions. Some economists argue that the Fed is behind the curve, as they say, that it should raise rates soon before inflation gets out of control. And investors are watching this debate with great interest because a decade of extraordinarily low interest rates has helped push prices for stocks and bonds to lofty levels. If rates rise, the thinking goes, investment returns might suffer. But then again, if inflation remains high, money will lose more purchasing power. So investors are wondering how to protect themselves. We'll come to that in a bit. Now, Adam, you and I have something in common. We were both born in years with inflation of around 3%. For you, it was 1992, and for me, 1972. In my case, the calm quickly gave way to the defining macroeconomic event of the second half of the 20th century called the Great Inflation. During the 1970s and early 1980s, there were two long stretches of double-digit yearly price increases. Those are often attributed to twin oil shocks, including a Middle East embargo.

For millions of Americans, this may be the worst weekend they've ever faced for finding gasoline to give them the automobile freedom they take as their due. You're only supposed to pump to 8 o'clock.

I have to be at work at 8. I came here at 6:30.

6:30 and you expect to get gas at 6:30 in line? Forget it, lady.

But we can point to another cause too: fear of the Phillips Curve. You see, the defining macroeconomic event of the first half of the 20th century was the Great Depression. And it made the great inflation of my lifetime look like a picnic. Inflation wasn't a problem during the Depression. Prices plunged, but one quarter of workers were jobless at one point. Belt tightening wasn't just a metaphor back then. One study of prison records found that a typical man who was locked up during the 1930s weighed 5 pounds less than men from decades before. In the late 1950s, many economists came to believe that unemployment and inflation were a direct trade-off, and that relationship is represented by what's called the Phillips Curve. But the Great Inflation proved that inflation and unemployment aren't always inversely related. You can have a lot of both at the same time. Eventually, a new Fed chair named Paul Volcker took aggressive action to fight inflation, and interest rates rose, and there were two recessions in the early 1980s, but America pulled out of them and enjoyed decades of moderate inflation and healthy growth and falling rates. So what will be the defining macroeconomic event of this 50-year period, the first half of the 21st century? It's too early to say, of course. Already we've had profound booms and busts and a rapid run-up in government debt. Some economists predicted that that would cause high inflation, but inflation has been exceptionally low, and there are theories on why. For example, average ages in developed countries are rising, and older workers spend less than younger ones and save more. Skewing demand toward financial assets rather than consumer goods. So this recent jump in inflation has caused some investors to say, here it is, all that government spending combined with ultra-low interest rates is creating that price spike that we expected. And others are saying, no, this is temporary, inflation will come down. Both are fair arguments, but Adam, I want you to watch out for what I'll call Turkinomics. America in 2021 is a place of deep political divide where some people choose their economic arguments or even their facts to fit their sides, and that can cloud the discussion around inflation. There was a report just before Thanksgiving from the American Farm Bureau, a lobby group. It said in the headline that the cost of a turkey dinner had shot up by 14% from last year. But the Department of Agriculture released a report around the same time that said prices for Thanksgiving dinner staples rose only 5%. So how can that be? Well, the Department of Agriculture used advertised turkey prices from the run-up to Thanksgiving, but the Farm Bureau used volunteer shoppers who collected turkey prices from an earlier period starting in October. Before stores had put turkeys on sale for the holiday. It also assumed families bought bigger birds. It noted in the body of the report that if it had waited a couple of weeks to collect turkey prices, the number would have been similar to those reported by the Department of Agriculture. But that nuance didn't make it into the headline or the many pun-filled TV news reports about how Thanksgiving dinner was gobbling worker pay. Investors should be careful to collect inflation views from a variety of sources and do their best to keep political passions away from their portfolio decisions. Speaking of which, Adam, let's bring in some help on what to do about inflation right after this short break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. Time for that help on inflation. Oh, hi, Katie.

Hello. Can you guys hear me?

I can hear you just fine. That's Katie Nixon. She's the Chief Investment Officer for Wealth Management at Northern Trust. Which oversees close to $1.5 trillion for investors. I asked Katie, what does she as a CIO make of the widely different takes we're hearing on inflation from economists?

The crystal ball question. So here's the thing, and I think you really nailed it. And it's so interesting that you started asking about the economist versus the strategist and CIO view, because they can be really different. I think economists spend a lot of time talking about what the Fed should do. I spend time thinking about what they will do, not what they should do. I don't care. It doesn't matter what I think they should do. If I think they should taper more quickly, if I think they should start raising rates, what matters is what they will do. And that is the thread that gets pulled through the other issues that you brought up related to where to invest, what about valuations, things like that.

Okay, so let's put policy opinions aside. What does Katie think the Fed will do?

Our view is that the market's ahead of itself in terms of inflation expectations. You can look at the 5-year breakeven, you can look at the TIPS breakeven, pick your, pick your poison. The market is anticipating that inflation is not transitory for the next several years, and it's going to be well above the Fed's target, even if you want to use the average inflation targeting. We think that's a bridge too far. We have our first rate hike maybe late 2022, most likely 2023. We think inflation is transitory. We're holding on to our Team Transitory t-shirts here. And I think it was very interesting to see that some of the data this week that showed that some of the pressures are alleviating.

Team Transitory, by the way, I think you guys are going all the way in the softball league this year.

I think we're going to make it. Yeah.

You heard Katie mention breakevens and TIPS. Both of those refer to ways to use bond prices to measure inflation expectations. For example, a 5-year Treasury recently yielded 1.33%. There's also a 5-year Treasury Inflation Protected Security, or TIPS, which adjusts over time to keep up with inflation reports. And that yields -1.67%. That's right, negative. And that's not because it's for financial masochists who take pleasure in losing money. Although if that's what you're into, I'm not judging. I hope you find happiness. Maybe buy naming rights to a stadium. I also hear good things about losing money on boats. Jackson, you have any financial masochism ideas?

Yeah, I saw this guy on TikTok making leveraged bets on Yu-Gi-Oh cards.

You can't go wrong if you're trying to go wrong on financial TikTok. Anyhow, TIPS are for people who think the inflation rate will more than make up for the negative yield start. Now, the difference between the regular Treasury yield and the TIPS yield is 3%, and that's roughly the amount of yearly inflation you'd have to see over the next 5 years for those two types of Treasuries to be equal deals today. The Fed is targeting an average inflation rate of 2%, so the bond market is saying the Fed is being too soft on inflation. And when Katie says the market is ahead of itself on inflation expectations, she means that she thinks the bond market, not the Fed, has it wrong. She thinks some inflation hedges like TIPS look expensive and that taking a narrow approach in investing for inflation could be costly.

Some of those asset classes that you reference that are so tied to inflation are, in our mind, very overvalued. I mean, you mentioned, or I mentioned, TIPS. That is pricing in a level of inflation that we think is way too high. If you think the TIPS market is overdoing it, you don't want to be owning TIPS.

But Katie also says that even a little inflation adds up over time, so investors should protect themselves. But many are already better protected than they might realize.

Even in a low inflation environment, you need inflation protection. And so there are places that give you inflation protection but aren't making a big bet on inflation, things like listed infrastructure, real estate, equities. Equities do fine up to a point in an inflationary environment. So you're probably better positioned for inflation than you think you are right now owning the S&P 500 and global real estate.

Let me zero in on one of those assets: stocks. Maybe your expectations for inflation are higher than Katie's. If so, you might assume that inflation will force interest rates higher and that stock prices will suffer. And you might be right. But consider for a moment how incomplete our knowledge is on stocks and inflation. Modern stock indexes and performance tracking are barely 60 years old. Explicit Fed targeting of inflation levels goes back only to the mid-1990s. Interest rates today are near historic lows, so even if we knew how stocks respond to rising rates, we wouldn't necessarily know how they respond to increases from these levels. What we can say is that stocks have in the past produced double-digit average returns during quite different inflation regimes. For example, over the 15 years ended in 1988, when average inflation topped 6%, and during the next 15 years when it was below 3%, and during the 15 years after that when it was closer to 2%. And that makes sense. Stocks represent companies, and companies own assets like real estate that can increase in value during inflation. Companies are also run by people who can respond to changing conditions, including inflation rates. Compare that with gold, which is called an inflation hedge but which has a spotty record on that front. Gold lost value during bouts of elevated inflation from 1980 to 1984 and from 1988 to 1991. But if you like gold and you own an S&P 500 fund, rest assured that it has a bit of exposure to gold mining. Adam I think the answer to your question, are you insulated from inflation by owning blue chip stocks, is yes, about as well as you can be. Now, if you're picking your own stocks, you can try for more of an inflation-protected tilt. UBS a while ago recommended shares of companies it believes have lots of pricing power. Its list included Nike, Coca-Cola, Generac Holdings, the generator company, and a real estate investment trust called Extra Space Storage. And Goldman Sachs said to stay away from companies with a combination of high labor costs as a percentage of revenue and low median pay, because those companies could get pinched by wage inflation. Its list included daycare provider Bright Horizons Family Solutions and casino operator Las Vegas Sands, and AutoZone, the retailer. But again, I don't think investors should take too narrow of an approach. Factors like valuation and long-term growth potential are surely more important than whether a stock fits a particular inflation theme. You also asked about bonds, Adam. I've seen some investment banks recommending adding junk bonds, and I get what they're saying. An index of junk bonds recently yielded 4.4%, which is close to triple the yield of the 10-year Treasury. And if you expect more inflation, You might also expect robust economic growth, which would be good for business and might drive credit upgrades for some of those junk bond issuers. The problem is that the purpose of owning bonds to begin with isn't really to jack up returns. Here's Katie.

You know, we often say to our clients, assets serve a purpose. Every asset in your portfolio should be there very intentionally. High-quality fixed income is there to provide diversification. You're right, there's no income. It's there for diversification. Risk assets, things that act and look and behave like equities, like high-yield bonds, are risky assets. Don't confuse them or conflate the two. So high-quality fixed income still holds that diversification benefit in your portfolio, and nothing else gives you that same bang for the buck. Now, the return profile is uninspiring. There's no doubt about it. It's like an insurance policy. You hope you never have to use it, but you're glad it's there when you need it, which is when the market gets stressed. We're in this incredible period of back-to-back all-time highs in markets. That's not normal. We will have a correction. And when you have a correction, you're going to be glad you have high-quality, short-duration fixed income.

So, Adam, I think your specific question was, should you add bonds if their prices fall and yields rise? And the answer is maybe, but a young guy like you should probably be mostly in stocks, and you should have a bit of short-term high-quality bonds already even though yields stink. But it sounds to me like you're doing great. I think we're going to hear a lot more heated debate about inflation in the months ahead, and I don't want to downplay how difficult it can be for folks with tight budgets when prices rise. The truth is, if I pay a few more dollars at the gas pump It doesn't make a bit of difference in how I eat that week, but for many families it does, and for their sake, I hope the inflation rate falls in the months ahead. And whatever happens, I'll try my best to make sense of the facts, not the hollering. I'm confident that stocks will be a big part of the answer for long-term investors. When you buy into them, you basically hire a vast army of smart people who work to create value as conditions including inflation, change. Anything to add, Jackson?

Yeah, I got another TikTok one for the financial masochists.

Go ahead.

Yeah, there's a person on here promoting lunar real estate as part of any balanced portfolio.

Well, there's no Case-Shiller Lunar Index, so I can't tell you how that correlates with inflation. I'm concerned about the fuel prices, if I'm being honest. I think folks should do their due lunar diligence.

Makes sense.

Thank you, Adam and Katie. And everyone, if you want to become famous like Adam, please keep the questions coming. Just tape on your phone. Don't laugh. That's— I'm sorry, guys. Signing autographs right now in Seoul. Use the voice memo app and send it to jack.hou@barons.com. Thank you all for listening. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @JackHough, H-O-U-G-H. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.