Can we protect ourselves from inflation?
The answer may surprise you. Yesterday we received news of a dramatic increase in inflation. The headlines focused on the year-over-year number, but that misstates the problem. After all, a year ago we were still in the middle of the pandemic. The vaccines hadn’t been approved. There were no effective therapies outside of a hospital. Prices for core goods – excluding food and energy – were up only 1.5%. Clearly, the pandemic had a deflationary effect on travel, entertainment, and office rental space.
Fast-forward a year, and those prices have taken off. But the question isn’t how much they’ve changed from a year ago, but how much they’ve changed from before the pandemic – looking “over the valley,” so to speak. And it’s important to look at the most meaningful prices. After all, if we try to exclude food and energy from our own consumption basket, we’ll be hungry and cold all winter!
When I look at core inflation, I like to examine a measure that the Federal Reserve calculates, called the “trimmed mean” inflation rate. Every month, they exclude 16% of the most extreme indicators – the 8% that rose the most, and the 8% that fell the most. This measure then weights the remaining components based on the average consumer’s monthly “basket.” So, as an example, education is more important than auto insurance, which is more important than jewelry prices. This trimmed mean inflation rate tends to move in the same direction as other inflation measures, but can also give a sense of how severe things are across the entire economy. After all, if the price of used cars spikes, I might just wait a couple of months for things to settle down and buy a used car then. The trimmed mean measures how seriously the core trend in inflation affects the average consumer.
And what does the 2-year average of the Fed’s Trimmed Mean CPI tell us?
Ouch. Core inflation hasn’t been this high since just before the Global Financial Crisis. It’s a hot, sticky mess, and doesn’t look “transitory” at all. Indeed, this measure of the trimmed-mean CPI has been trending higher since 2015. It’s not a question of whether inflation is here. It’s now a question of what to do about it.
I’ll leave the policy questions to policymakers – how to tame inflation, how to fix our supply-chain issues, and whether the Fed should let inflation “run hot” for a while to catch up with a decade of sub-target performance. These political decisions involve all kinds of trade-offs. The question for investors is how to manage inflation-risk in our portfolios, and what kinds of instruments can provide an active hedge against the power that broadly rising prices have to erode the value of our nest egg.
Small investors have some special tools at their disposal. Notably, the US Treasury has been issuing Series I Savings Bonds since 1998. Investors are limited to purchasing only $10,000 per year, But the bonds are indexed to inflation plus a spread and the principal is guaranteed by the United States. The minimum holding period is one year; the maximum holding period is 30 years. Currently, I-bonds are yielding 7.12%, and are available for purchase on the US Treasury website.
In addition, the Treasury has been issuing TIPs (Treasury Inflation Protected Securities) since 1997. These trade on the secondary market and can be purchased via mutual funds and ETFs – although it mystifies me why anyone would pay even a nominal fee for something that is guaranteed by the government and “free” to hold. Investors can hold them in most brokerage accounts, and institutions can purchase TIPs bonds in size. If someone had purchased one of the original long-term TIPs bonds, they would have earned a rate of return competitive with the stock market:
These bonds are direct hedges against inflation. Can stocks provide protection against inflation? The conventional wisdom says yes, good companies will “power through” inflationary periods with stronger corporate earnings. But what does the market show? After all, most investors today have little experience with inflation. But there is ample market data from prior periods. Nicholas Raberner of Factor Research published a study on the CFA Institute website. He looked at monthly market returns in four different inflation regimes: below zero, zero-to-5%, 5%-to-10%, and greater than 10%. The real (inflation-adjusted) returns are striking:
Source: Nicholas Rabener, CFA Institute.
Stocks do much better when prices are stable. It’s hard for companies to pass through their costs when prices are rising dramatically. The long-term best returns come from innovation and operational efficiency, which is much more difficult when the cost of capital is constantly increasing.
We’ll look at other ways to protect against inflation next week. For now, investors should know that yes, there are ways to protect yourself; and no, nothing is risk free.