The seismic events of 2020 and 2021 have brought inflation out of the woodwork and into mainstream for all Americans. Unease about rising prices has reached a magnitude reminiscent of the hyperinflationary period of the 1970s. Since then, the inflation genie seemed to be back in the bottle thanks to painful interest rate hikes and other drastic measures taken in the late 70s and early 80s. Recently, deflation even appeared to be the greater cause for concern with central banks using their toolkits to nudge prices up after back to back recessions in the 2000’s created a slow growth economy. As most Americans are now aware, the economy changed radically due to the COVID-19 pandemic: massive government stimulus combined with unprecedented efforts from central banks has put enormous upward pressure on producer and consumer prices. News outlets and investment analysts are warning of negative consequences from persistent inflation that seems inevitable.
Despite the headlines, personal finances don’t have to suffer hopelessly from rising prices. Below are three key tips and ideas for navigating your money management during inflation
1. Biggest Investing Mistake to Avoid During Inflation: Reaching for Yield
Fixed-income investments have long been a safer choice for investors to earn a decent return while counterbalancing the volatility of riskier stock investments. The 10-year treasury yield peaked over 10% in the 1980s and has steadily declined since then to a current 1.30%. The higher rates of years past allowed corporate, municipal and government bonds to offer a fantastic return that provided competition for stocks. The ultra-low rates of today (and for much of the last 10-15 years) basically guarantee a negative return for most investment grade bonds after inflation factors in.
So what do you do? Looking further out on the yield curve for longer term investments was once a fairly consistent way to find higher rates. Now, however, this strategy doesn’t provide enough extra return to justify the huge risk of inflation eating away at your fixed coupons for years. The “yield curve” is essentially flat with the 30-year treasury barely paying 0.50% more interest than the 10-year; hardly enough for 20 extra years of risk.
This may lead investors to the junk bond market in search of higher rates. There is an abundance of junk bonds to choose from as companies rushed to sell cheap debt in recent years. In February 2021 the average Junk bond yield fell below 4% for the first time ever, which translates to them being historically expensive. Like longer term bonds, junk bonds don’t offer a large enough premium to justify their risk. Simply put, the current risk-return trade-off is historically bad for bond investors.
To avoid unnecessary risk, Winthrop is investing exclusively in solid investment grade bonds with maturities under five years. We have long emphasized that bonds should be used as a store of value or cash proxy rather than a place for capital appreciation. Besides the youngest and most risk-tolerant investors, most portfolios require a healthy allocation to bonds and other safer investments. While it isn’t the sexiest investment idea, short term bonds (under five years to maturity) with high credit
qualities (BBB+ or above) should continue to balance portfolios against volatility without being exposed to significant risks of inflation or default. Treasury Inflation Protected Securities (TIPS) are another safe bond option that offer specific inflation protection. TIPS pay a fixed dollar coupon twice a year, but the maturity value changes up or down with the consumer price index.
Successful investing is largely dependent on avoiding big mistakes; taking on a large amount of risk for a few more percentage points looks likely to offer painful results.
2. Inflation should ease the burden of high debt
Americans are saddled with record amounts of personal debt. Student loan and credit card debt are sticking with people much later into life than in previous generations. Inflation can be both good and bad for managing debt levels. Starting with the negative effects: inflation would cause interest rates to rise, which in theory would mean variable rate debt like credit cards would cost more. In reality, credit card interest rates have stayed stubbornly high even as other rates fell, giving card issuers less wiggle room to raise them more in the future. The benefits of inflation for borrowers are more straightforward: the amount you have to pay back is usually locked in when you borrow. Inflation means that future dollars are worth less than they are now, so your debt balance will be less of a burden as time goes on. Additionally, wages usually increase more during inflationary periods than otherwise. More money in your future paychecks will obviously allow debt to be paid down faster. The last piece of good news is that interest rates are still historically low despite inflation fears. Borrowers can lock in low interest rates now if they believe inflation will indeed continue to run hot.
It is never a bad idea to pay down debt when you have the ability to do so. Interest rates on savings accounts will almost certainly never achieve parity with borrowing rates, so cash in the bank is worth less than cash used to pay back borrowings. Keeping an eye on inflation measures like the Consumer Price Index will allow you to budget more efficiently and make better decisions on managing debt.
3. Investing in stocks is still a worthy inflation hedge, but consider diversifying more than usual
Unlike the relationship between bonds and inflation, which mostly relies on simple math, the stock market has a complex dynamic with rising prices. The most relevant precedent is the 1970’s, when inflation ran high for years and the stock market suffered negative returns for the decade. Despite this example, there is certainly no guarantee that the stock market and inflation will be inversely correlated moving forward. The relationship will depend on what type of prices are being inflated and what industries will see the greatest impact.
Higher inflation should benefit the stock market in a few general ways: companies can increase prices, existing corporate debt becomes cheaper, and demand for stocks increases with more dollars in the financial system. The major drawback of higher inflation is that interest rates will rise in response, upending one of the major drivers of the stock market boom since the 2008 financial crisis. Stocks have been incredibly sensitive to interest rates and just a simple change in verbiage from the Federal Reserve can send stocks flying or tumbling. A major theory supporting the current high stock valuations is the idea that low interest rates increase the present value of future corporate earnings. The “discounted cash flow” method for valuing a company takes estimated future earnings and discounts them back to a single present value. The lower the discount rate used in the equation, the higher the present value of
those future cash flows. On top of making future earnings look better, low interest rates also mean stocks have less competition from bonds for investor dollars. As discussed earlier, low interest rates on bonds offer measly returns, which has pushed more and more investor money to the stock market. More demand for stocks means higher prices for stocks.
Given how much fuel the stock market has gained from low rates, shouldn’t the stock market suffer if inflation remains hot and interest rates have to rise? The reality will probably not be that simple. Firstly, higher rates as a result of higher inflation would likely keep real returns on bonds low despite higher nominal coupon rates. If bonds continue to offer poor returns after inflation, investor dollars should continue to flow into stocks in search of better performance.
Another major consideration is which stocks will suffer and which stocks could thrive with inflation. The leaders of the stock market over the last decade have been mostly high-growth tech stocks that pay little or no dividends. These stocks would be expected to take some of the biggest hits from inflation and higher rates. To make it even trickier for investors, the five largest companies in the S&P 500 (Apple, Microsoft, Amazon, Facebook and Alphabet) now make up almost 25% of the entire index after years of stellar returns. Index investing is more popular than ever, leaving many investors are exposed to the risk of overconcentration in a few large stocks that could be hit hard by inflation hanging around.
The good news? There are 494 other stocks in the S&P 500, many of which are well-positioned in industries that could benefit from inflation. Financials, Healthcare, and Consumer Goods are three sectors with stocks that generally pay solid dividends and offer protection from rising prices. Financials like banks and insurance companies would directly benefit from higher interest rates. Healthcare and Consumer Staples include many stocks that are able to pass on price increases without stifling demand for their products. Even some technology stocks with important products and low debt loads appear well-positioned to cruise through a period of higher inflation and higher rates.
As long as inflation doesn’t go parabolic and cause a severe contraction, many stocks will continue to provide great performance for investors. The key element is diversification: spreading dollars out to avoid heavy investments in past performers and adding to companies in sectors that are better positioned for higher prices and inflation. Rebalancing portfolios has never been more important.