In the 90s movie The Shipping News, an old newspaperman Kevin Spacey explains how to cover the news. If a storm is visible somewhere, he explains, write “Storm Threatens the City,” even if the storm isn’t nearby and probably won’t strike. If – as expected – the storm never strikes, just write the sequel: “City spared by storm.”
Readers may be excused if they think similarly about the latest stories of looming, looming, rising, terrifying inflation. Yes, inflation forecasts rose months ago and reached their highest level in 8 years. If they had continued, there would be cause for concern. But they didn’t go through. On the contrary, they have been falling for two months. The 5-year inflation forecast for the bond market is now lower than in mid-March. The market sees five-year inflation at around 2.6%. That’s higher than we’ve been used to for ten years, but it’s nothing to sound alarming.
That can of course change. Maybe it will. We will see.
But with all this talk, I started thinking about the obvious question. If inflation really hits, what can we do about it? How can we protect our investments?
That’s a particularly important question for today’s retirees and those who expect to retire soon. As we get older, we are generally advised to keep most of our money in more “conservative” investments, ie things like bonds, which carry less risk. Someone in their twenties or thirties may not have too much to worry about if their 30% retirement savings lands in a market crisis or inflation spiral. For someone in their 60s, let alone older, that could turn into a major financial crisis.
So I went back and dug up the information from the last infamous inflation spiral in the 1970s, when consumer price inflation was often more than 10% a year. The Greek philosopher Heraclitus pointed out that no one ever goes through the same stream twice because it is not the same stream the second time and we are not the same person. Everything changed. There’s no guarantee that the next inflationary boom, even if it does happen, will look anything like the previous one – any more than we should assume it will be accompanied by bursts of disco music and flared jeans.
Nevertheless, the chart above shows the total returns, after adjusting for inflation, of various asset classes from December 1971 to December 1981. (I used that data because that’s when the National Association of Real Estate Investment Trusts, or NAREIT, launch their data series.) energy stock data comes from data collected by Professor Ken French of Dartmouth College’s Tuck School of Business.
This is what happens to your purchasing power when you invest in these assets and hold them for 10 years. (I excluded gold, which is another story.)
The most important thing is that you really not done to own government bonds. The nearly 40% loss of purchasing power over a 10-year period is somewhat fictitious — it’s derived from the compound annual returns on 10-year Treasuries compiled by New York University’s Stern School of Business, divided by the Consumer Price Index. – but tells a story nonetheless. (In Britain, where inflation was even worse, government bonds became known as ‘certificates of confiscation’ in the 1970s. Ouch.)
Holding it will cost you money. Lots of it.
You could argue that the danger is even greater today, simply because long-term government bond yields are so low. The Federal Reserve’s quantitative easing, bond buying and zero-interest policy have pushed government bond yields to all-time lows — meaning the turnaround would be a disaster if inflation were to hit.
Corporate bonds and the S&P 500 SPX,
were also terrible investments. It’s worth remembering that these are real-term losses over a decade, meaning that investors have not only lost a lot of money, but a lot of time.
Utility supplies weren’t great, but they held up better. And treasury bills – short-term paper – did even better. But again, you went backwards when you had to go forward.
No one who remembers the 1970s would be surprised to see energy companies boom. Perhaps less well remembered is that REITs also did pretty well. Incidentally, these numbers represented real estate-owning REITs and excluding mortgage REITs, which own loans.
But there are two caveats to be made here. The first is that energy stocks did well, of course, because the rise of OPEC and two oil embargoes it imposed on the West for political reasons was a major driver of inflation in the 1970s. Say Heraclitus. There is no particular reason to believe that the next wave of inflation will be the same.
The second caveat is that while REITs did well in the end, they were volatile along the way. In particular, REIT prices collapsed during the OPEC-driven recession of 1972-4. And according to FactSet, U.S. REITs already look pretty expensive these days for some measures. For example, it estimates that the projected dividend yield on the Vanguard Real Estate ETF (a reasonable measure for the industry) is just 2.9% — by far the lowest since its launch in 2004. Looking through NAREIT data, I can’t imagine a moment since 1971, when total returns on REITs were so low. During the property bubble in 2007, the yield did not fall below 3.6%
So it may be that REITs today offer less inflation protection than we’d hope.
An important difference in the 1970s is that there were no “inflation-protected” government bonds to protect investors. So-called TIPS are, in theory, almost the perfect investment for retirees. They are issued by the US government and their coupons are secured against payment default. Meanwhile, their coupons are effectively adjusting to reflect changes in consumer prices.
The problem today is that TIPS, like almost everything else in the bond market, looks incredibly expensive. Most TIPS already hold an actual loss of purchasing power if you buy them today. For example, if you buy 5-year TIPS bonds and hold them for 5 years, you’ll end up losing 9% of your purchasing power. And 30-year TIPS bonds offer the same 9% loss, even though they stretch over 30 years.
It’s not very compelling. And it shows the risks that government policy responses have created for retirees and near them.