June 3 2022
I believe that current high levels of inflation will be transient. However, I believe risks remain to the upside. In this article I will draw upon the historical precedent of the 1970’s to show how the experience during that decademight suggest that the risk of an outlier scenario of persistent high inflation may be greater than what many think. Inthe words of Mark Twain “History doesn’t often repeat itself but it often rhymes”.I will then look at which asset classes provided the best protection during that period and which asset classes mightprovide the best protection today should this type of outlier scenario materialize today.
Unfortunately, rather than allaying one’s fears, any comparison of the situation today with the 1970s providesUnfortunately, rather than allaying one’s fears, any comparison of the situation today with the 1970s providesadditional cause for concern.Firstly, the decade of the 1970’s began with monetary debasement, which draws an obvious parallel with the era ofeasy money that has followed the Global Financial Crisis (GFC). Secondly, the high inflation experienced during thatperiod was also made worse by two exogenous shocks, similar to the two shocks – re-emergence from Covid, theUkraine crisis – that have contributed to the situation today.Looking back, the stage for the stagflation of the 1970’s was set at the beginning of that decade with the “NixonShock”.
This refers to the announcement made by Nixon on the 15th of August 1971 when he announced a combinationof wage and price freezes, import surcharges and, most importantly, suspended the convertibility of the dollar intogold with immediate effect.This action dismantled the Bretton Woods fixed exchange rate system. In terms of that system the US dollar waspegged to (and redeemable) in gold at a fixed price of USD 35 per ounce and all other currencies were pegged to thedollar. Bretton Woods had served the world well up till then but the fiscal imprudence of the US during the 1960s (partly tofinance the Vietnam war), as well as its negative balance of payments ultimately made it unviable because the US goldreserves became insufficient to cover its dollar liabilities. Because of this, some of the US’s trading partners beganrequesting redemption of their dollars for gold and this posed a risk that there would be a run on the US’s goldreserves.It was not just the Nixon Shock which contributed to the high inflation of the 1970’s, however.
The situation was worsened by two oil crises during that decade.The first of these, in 1973, was caused by OPEC countries embargoing countries which supported Israel during the YomKippur War. This saw the price of oil rise from US$3 per barrel to US$12 per barrel. The second, in 1979, was causedby the Iranian Revolution which removed Iran’s production from the oil market. This saw a doubling in the oil pricefrom US$20 per barrel (immediately prior to the crisis) to US$40 per barrel.Fast forward to today and the notion of a “hard” anchor for currencies has been absent for a while but it is hard notto wonder whether a currency debasement of another type, in this case the easy money era following the GFC, mightpose a problem. This view gains further credence if we look at the popularity of cryptocurrencies like Bitcoin whose adherents take a lot of comfort from the fact there is a fixed number of Bitcoins that may be issued and no monetaryauthority can issue them at will. As stated above, two exogenous shocks – re-emergence from Covid, the Ukraine crisis– have also contributed.Very high levels of inflation are bad for the economy. When inflation is moderately high academic research is actually divided as to whether it is bad for the economy.
It is only when inflation crosses a certain (high) threshold, that opinions align that it is bad.There are many reasons for this. Firstly, very high rates of inflation erode the purchasing power of consumers becausea basket of basic items costs more. Secondly, it discourages investment in capital items, because it erodes the depositbase of banks and their ability to lend. Finally, it is bad for asset prices, causing people to feel poorer and spend less.
The chart below shows the returns provided by various asset classes when inflation exceeds 5%. Most of theseThe chart below shows the returns provided by various asset classes when inflation exceeds 5%. Most of theseobservations were recorded in the 1970’s.
Source: Bernstein
Historically when inflation exceeds 5%, commodities have been the best performers (oil as well a broader commodityHistorically when inflation exceeds 5%, commodities have been the best performers (oil as well a broader commodityindex take the first place and second place respectively). They have been followed by gold in third place and then byUS REITs in fourth place.
Interestingly, while both performed poorly, US bonds actually outperformed US equities which is not a result thatmany people would have expected. The reason for this is twofold: firstly, equities underperformed because very highrates of inflation are often accompanied by low economic growth rates as explained above (hence the term“stagflation”) and, secondly, they are long-duration assets so equity valuations suffer as the result of a higher discountrate being applied to the stream of future cashflows that equity holders are entitled to.
To what extent would we expect asset class returns to mirror the past if we experienced a period of outlier highinflation today? I believe that there is compelling argument to be made that instead of commodities and gold, certaintypes of REITs, specifically those with short duration leases, might be the asset class that performs the best. The reasonfor this is that both commodities as well as gold have very significant shortcomings which may be hard to overcome.
Let’s begin with the shortcomings of commodities. The cleanest way for portfolio investors to gain broad commodityexposure is through a collateralized futures ETF rather than an ETF which holds the various underlying commoditiesdirectly. Collateralized futures ETFs, like physically backed futures ETFs, carry an implicit charge for cost of storing thephysical commodity (which can be high for certain high volume, low value commodities). They also carry a secondcharge, an implicit interest charge. This charge is to prevent cash-and-carry arbitrage between the futures and physicalmarkets and could provide a very large offset as interest rates typically rise in tandem with inflation rates.
Gold also has its shortcomings. Unlike other commodities, the largest gold ETFs are physically backed. As I statedabove, there is no implicit interest rate charge built into pricing of physical gold ETFs but there is a “negative carry”from holding gold which is the opportunity cost of holding an asset which doesn’t provide an income. This may impairits desirability as an inflation hedge. Secondly, the role of gold as a store of value has been entrenched for centuries,but there are a number of asset classes vying with it for this role today, amongst them various cryptocurrencies. Theseasset classes may further impair its desirability as an inflation hedge.
REITs surmount all of these problems. Firstly, there is no implicit interest rate charge or negative carry that need to berecouped, only an opening yield which is typically set to grow in line with contractual, often CPI-linked, escalations.Property valuations also tend to rise with inflation. Lastly there are no storage costs.
Not all REITs are created equal, however, and it is those with short duration leases that will be better at passing onrising inflation.
While I expect inflation to be transient, the risks of the situation today evolving into scenario of persistent high inflationis far from zero. The 1970’s has concerning parallels with the situation today and once inflation takes hold, it is veryhard to stop it in its tracks. The cycle of negative (high) inflation expectations becomes self-reinforcing.
I believe investors with multi-asset mandates should hold small positions in all asset classes that have proventhemselves as inflation hedges, and specifically re-evaluate the role that REITs might play, as this might prove veryvaluable in a portfolio context. Even if your base case is for a relatively benign outcome, it pays to buy insurance againstthe worst.