Protecting your portfolio from inflation
What is a poor investor do? History does not paint a pretty picture. During the inflationary years of 1972-1982 real (afterinflation) returns on the S&P 500 were effectively flat. Having your money in the stockmarket could protect it from debasement, but that was all – it could not generate spendable returns. Yet when you compare the stockmarket with bonds, it looks like a positively excellent bet – US equities yielded an average of 1.3% a year during this period versus 0% on corporate bonds, and a dismal loss of 1.8% a year on ten-year Treasuries.
If you did take a punt on stocks in an inflationary environment, does history indicate that there might be any way to boost your returns and thus prevent your portfolio from simply treading water? Possibly. “Factors” (which are specific characteristics that have historically enabled companies that share them to beat the wider market over time) appear to have performed well during inflationary periods. In the 1972-1982 period, tilting your portfolio toward the momentum, value and small cap factors would have given it a boost, with the three factors far outstripping their historical average outperformance, as the chart shows.
Value (red line) and momentum (black line) stocks both vastly outperformed the market in the period. After adjusting for inflation, they had doubled in value relative to the market which was effectively flat. In other words, for every dollar an investor in the total index earned, investors in these factors earned two. These are actual, spendable gains. (Most people correctly assume that value and momentum are polar opposite strategies and in cyclical terms this is often correct; however over the long run, both generate excess returns and clearly during the 19721982 inflation they did this in lockstep.)
Small cap (blue line) stocks did poorly initially, but were able to stage something of a comeback, eventually accumulating a 50% premium to the market – again, real spendable gains. Meanwhile, the stocks that did badly were (logically) the flipside of these factors, such as growth stocks and large caps.
That said, stockmarkets cannot be judged without reference to how expensive they are. The US market in particular stands out on this basis. If we start experiencing heavy inflation and multiples on the S&P 500 remain at today’s nosebleed heights, it might be worth thinking twice before going all in.
And while there are now plenty of exchange-traded funds (ETFs) which allow private investors to track the hallowed factors mentioned before, investing in these can be a complicated business which requires more than a little skill and thoughtfulness, not to mention making sure that you’re using the right ETF. Also just because they did well in the last inflation, that’s not a guarantee that they will repeat this in the next.
So before jumping into any of these strategies with both feet, it is well worth considering the security that inflation-indexed bonds offer – although if inflation doesn’t turn out to be here to stay, they may turn out to be a very frustrating investment. And that is an added point to note– inflation is not a sure thing. Crystal balls cost more in credibility than they are worth. The Covid-19 fear factor may dissipate; employers may realise that vaccine mandates will cost them dearly, or vaccine-hesitant workers might throw in the towel.
But if we keep these dynamics in mind, they will help us to identify a serious inflationary environment if we enter one. At that point, tough asset allocation decisions will have to be made.