With economies powering ahead around the world, concerns have largely shifted from collapsing share markets to coming inflation. While these fears have been more or less constant for the past decade, it seems today's low interest environment has exacerbated concerns around asset prices.
Inflation risk is one of many risks faced by long-term investors. How does a long-term strategy deal with this particular risk? Should we be changing our investments based on expectations for inflation?
We don't believe inflation risk should be the primary driver of our decision-making process. We also don't believe inflation is the impending disaster we often hear about.
We wanted to briefly discuss some of the ideas around inflation and how they relate to a long-term strategy.
What is inflation?
Inflation describes how the things we buy in our day-to-day lives tend to increase in price over time. In NZ, when the Reserve Bank says inflation is at 1.5%, they mean the things an average New Zealander purchases have increased by 1.5% over the past year.
To represent this basket of goods and services purchased by the average Kiwi, we use the Consumer Price Index (CPI). The index tracks the prices of food, clothing, transport etc. over time.
At the macro level, the CPI is very effective for tracking how general prices are increasing. Individually, the things you spend on regularly will differ from those in the CPI. For example, according to this RBNZ calculator, the price of clothing has barely changed over the past twenty years, while housing costs have more than quadrupled.
If you owned your own home during this time, you would be largely unaffected by the increase in housing costs (actually benefitting from the high price for your home!). For this reason, Stats NZ also estimate inflation for different groups, including households with a range of incomes.
It is easy to think of inflation as an abstract force. However, the term simply describes how general prices increase over time.
How does inflation affect share prices?
If only the answer to this question were as simple as "share prices go up" or "share prices go down". In the short-term, it seems unexpected inflation is negative, as increased costs for materials and borrowing affects profitability. This doesn't guarantee negative share performance, but suggests that of the many key factors, inflation likely contributes negatively to the share price.
Eventually costs will be passed on to consumers, so the flexibility of pricing is also important in the short-term. Companies may actually do well depending on their industry and cash flows. Commodities like oil are often touted as inflationary hedges.
Over a longer time period, companies will adjust their pricing. After all, CPI is a measure of how much general companies are charging for their products and services. For this reason, we don't expect detrimental long-term effects due to inflation.
Share markets adjust rapidly to new information. While an unexpected bout of high inflation will lead to volatility, we believe prices will quickly reflect this. Long-term, inflation risk is once of many factors affecting share prices and shouldn't dominant long-term strategies.
How does inflation affect bond prices?
In modern economies, high inflation is accompanied by high interest rates, as monetary policy is a key tool used by central banks to control inflation rates. There are a few things to break down here.
An increase in interest rates and inflation are bad for short-term bond prices. As newly issued bonds will pay more than previously issued ones, investors will pay less for these older bonds. Also, inflation means the capital tied up in the bond will be able to purchase less.
For bonds with longer terms, the impact is less clear. Higher interest rates often increase prices, as they are implemented to control inflation itself.
The returns from bonds may suffer during unexpected periods of high inflation, or before a predicted period of inflation. However, bond yields will adjust to these new expectations quickly. Returns on newly issued bonds will reflect rising interest rates and adjusted expectations.
Should we adjust our strategy?
We build investment portfolios with a long-term view, a client-centric approach and a strategy based on what we can control.
First, inflation tends to be relatively consistent long-term. Short-term changes can affect performance now, but will be more predictable over a longer period. The best way to combat the increasing prices over many years is to earn a decent long-term return from your investments. This is why investors choose to include riskier assets like shares in their portfolios.
Regarding a client-centric approach, consider the role these investments play in a portfolio. Shares are used to generate a high return over time, with the acceptance that prices can be volatile in the short-term. Bonds are used to offset this volatility, though offer a smaller return. Cash is kept for short-term goals for which risk should not be accepted.
The mix of investments is chosen based on the timeframe and costs of a client's goals, and their attitude to risk. Despite potential short-term impacts of inflation, bonds will continue to offset the volatility of shares. These shares continue to deliver high returns over time.
Lastly, we cannot predict or control inflation any more than share prices, bond prices, or the weather. We can control how we react and build plans. We believe a long-term approach is better for our clients.
For your interest, we have included a brief conversation with David Booth and Eugene Fama regarding inflation below.
Inflation: An Exchange Between Eugene Fama and David Booth
With the economy starting to recover from the COVID-19 pandemic and investor concerns turning increasingly toward inflation, Dimensional Founder David Booth talked with Nobel laureate Eugene Fama about inflation and how investors should think about it in their portfolios. Excerpts from their conversation have been edited for clarity.
On Predicting Inflation
David Booth: Gene, you are a founding Director of Dimensional and have been involved in our research and corporate governance for more than 40 years. People may not know that you’ve also done a lot of research on inflation and interest rates.
We always tell people, “We don’t try to forecast. We try to be prepared for various outcomes.” Inflation is one of those things you want to be prepared for. There’s a pickup in inflation risk that wasn’t there, say, 10 years ago. Does that cause you to worry?
Eugene Fama: Historically what’s happened is, when there’s a spike, the spike persists for a long time. Inflation tends to be highly persistent once you get it. Once it goes down, it tends to be highly persistent on the downside. You’ve got to be prepared for that. Predicting next month’s inflation may not be very hard because this month’s inflation can be a pretty good predictor of next month’s inflation, or next quarter’s inflation, or even the next six months’ inflation. Persistence is a characteristic of inflation.
We haven’t been in a period of high inflation, or even moderate inflation, for at least 10 years, so I’m not particularly concerned that inflation will be high soon.
On How Investors Should Think About Inflation and Their Financial Goals
Booth: Conditions change, so is there anything about the current environment and the risk of inflation heating up that would cause you to change your portfolio?
Fama: I don’t think anybody predicts the market very well. Market timing is risky in the sense that you’ve always emphasized: You may be out of the stock market at precisely the time when it generates its biggest returns. The nature of the stock market is you get a lot of the return in very short periods of time. So, you basically don’t want to be out for short periods of time, where you may actually be missing a good part of the return.
I think you take a long-term perspective. You decide how much risk you’re willing to take, and then you choose a mix of bonds, stocks, Treasury Inflation-Protected Securities, and whatever else satisfies your long-term goals. And you forget about the short term. Maybe you rebalance occasionally because the weights can get out of whack, but you don’t try to time the market in any way, shape, or form. It’s a losing proposition.
Booth: As you get to the point in life where you actually need to use your portfolio, does that change the kinds of allocations you’d want?
Fama: The classic answer to that was, yes, you’d shift more toward short-term hedges, short-term bonds. Once you had enough accumulated wealth that you thought you could make it through retirement, you’d want to hedge away any uncertainty that might disturb that. That’s a matter of taste and your willingness to take risk and your plans for the people you will leave behind, like your charities or your kids. All of that will influence how you make that decision. But the typical person who thinks they’ll spend all their money before they die probably wants to move into less risky stuff as they approach retirement.
Booth: The notion of risk is pretty fuzzy. For example, if I decide that I want to hold Treasury bills or CDs when I retire, and you did that 40 years ago, when we started the firm, and you’ve got that 15% coupon, that’s pretty exciting. With $1 million at 15%, you’re getting $150,000 a year. Today you might get less than 1%.
Fama: Right, but I remember when inflation was running at about 15%, so not much better off!
Booth: Those are different kinds of risks.
Fama: When you approach retirement, you’re basically concerned about what your real wealth will look like over the period of your retirement, and you have some incentives to hedge against that. You face the possibility, for example, that if you invest in stocks, you have a higher expected return, but you may lose 30% in a year and that might be devastating for your long-term consumption.
Booth: I think part of planning is not only your investment portfolio, but what to do if you experience unexpected events of any kind. We’re kind of back to where we start our usual conversation: “Control what you can control.” You can’t control markets. What you can do is prepare yourself for what you’ll do in case bad events happen. Inflation is just one of many risk factors long-term investors need to be prepared for.
