Inflation Risks Are Still Out There

“Gradual” is not synonymous with “irrelevant.”

road sign with black exclamation point warning about inflation

Source: Michael Wick / Shutterstock.com

If it were, then gradual wrinkling of the skin would also be irrelevant, but a multi-billion-dollar cosmetic surgery industry testifies to the contrary.

But gradual changes can produce surprisingly powerful effects over time. For example, nothing on the globe is where it used to be. The tectonic plates, as if inspired by a kind of geologic wanderlust, are constantly moving from wherever they were to wherever they will be.

A few billion years ago, the aboriginal inhabitants of Scotland could have teed up a prehistoric golf ball almost anywhere at the seaside locale that has become the St. Andrews Golf Links, taken a good swing toward the east with a prehistoric golf club and landed their drive in Denmark. That same tee shot today would land your Titleist in the North Sea.

How different the world might have been if those tectonic plates had simply remained where they were! How different… and how boring. If the tectonic plates had never separated, the planet might have never achieved its arresting diversity of flora, fauna and philosophies.

In other words, small incremental changes over time can produce miracles.

And in the world of finance, gradual changes are the ones that usually produce extraordinary success… or failure.

The article you’re about to read was published last October. Even though only five months have passed since then, the investment environment looks vastly different today, thanks to gradual, day-to-day changes that most of us never even noticed.  Clearly, gradual shifts are not irrelevant ones.

Watch Out for Inflation

By gradually compounding capital gains, an investor can transform a modest amount of cash into a multi-million-dollar nest egg. By contrast, investors who compound losses can rapidly erode a portfolio’s value.

To illustrate this point, let’s consider the experiences of two hypothetical investors who both started their investment odysseys 20 years ago with a $50,000 grubstake.

Bill is a gunslinging day trader who has suffered average annual losses of 10% during the last 20 years. Betty is a thoughtful long-term investor who has achieved average yearly 10% gains over the same timeframe.

Twenty years into the mission, Bill has frittered away all but $6,000 of his original $50,000. Betty has compounded her $50,000 into more than $300,000.

Obviously, few investors would be as reckless or luckless as Bill. But that doesn’t mean his story is irrelevant to us.

Let’s give Bill another name, and you’ll see what I mean. Let’s call Bill “Inflation.” Every year, inflation is eroding part of our nest egg. It is undercutting our investment gains.

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Most of the time, we ignore this slow-motion theft because it seems so gradual as to be irrelevant. But now that the inflation rate has jumped to 5.4%, it is becoming a bit more relevant.

Not only is it undercutting the purchasing power of our savings at the fastest rate of the last 30 years, but it is also threatening to spark a big jump in interest rates.

If that were to occur, stocks and bonds would certainly suffer… especially bonds.

And yet, very few investors seem perturbed by the rising inflation trend.

Inflation seems to worry almost no one, except maybe for a few academics and doom-and-gloomers.

Perhaps inflation seems so non-threatening because it looks so non-threatening most of the time. It causes its damage so gradually and stealthily that it doesn’t seem to be causing any damage at all.

But over time, inflation can wield a shockingly large impact. It has the power to destroy fixed income investments and also the power to crush stock market returns.

Inflation can be especially fatal to fixed-income investments like long-term bonds.

Consider the hypothetical case of an investor who purchased the 30-year Treasury bond that is currently yielding 2.01% per year.

  • If rising inflation caused 30-year interest rates to rise to just 3.0% over the next 12 months, the value of that bond would fall 20%.
  • If 30-year rates doubled from 2.01% to 4.02%, our hypothetical bond investor would be nursing a loss of more than 35%!

But we’re not done yet…

Let’s imagine that long-term interest rates returned to 6.35%, their average level of the last 45 years.

At that yield, the price of today’s 30-year bond would be down more than 55%!

Because of unfavorable math like this, the legendary interest rate expert, Jim Grant, sometimes refers to low-yielding bonds as “return-free risk.”

The Stock Market’s Kryptonite

The exercise above shows how severely inflation can punish a seemingly “safe” investment like a Treasury bond.

But inflation can also punish equities. Historically, stocks tend to thrive when inflation readings are low, but struggle when inflation readings are high. The chart below shows this inverse relationship, based on monthly data from the last 60 years.

The far-left bar in the chart, for example, shows that the S&P 500 index averaged yearly gains of more than 10% following CPI inflation readings below 1%. But the bar on the far-right side of the chart shows that the S&P 500 advanced less than 3% per year when CPI readings topped 9%.

A chart showing average annual stock market price gains following CPI inflation readings ranging from -1% to 11%.

If we were to take this analysis to the next step, we would subtract the inflation rate from the stock market’s return to calculate the after-inflation return, also called the “real return.”

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According to this analysis, the bar on the far left would have delivered a real return of about 9%, while the bar on the right would have delivered a real return of minus 6% at best.

Clearly, inflation is a financial toxin.

Today’s elevated inflation readings might subside over the next several months and turn out to have been much ado about nothing. On the other hand, investors may be making nothing to do about much — an inflationary trend that is both persistent and destructive.

Because of the collective nonchalance about the threat inflation poses, inflation hedges are relatively cheap. Metaphorically, the embers of inflation have already landed atop the thatched roof of American finance. And yet, investors can still buy financial “fire insurance” on the cheap.

The insurance called “gold” is especially cheap, relative to the protection it can provide during an inflationary episode.

Gold does not always provide minute-by-minute protection against inflation, but it tends to provide fairly reliable protection over time.

As the chart below shows, the gold price tends to remain fairly quiet during periods of relatively low inflation. But once the inflation rate kicks into high gear, so does gold.

The chart presents the average annual returns of gold and commodities, minus the average annual return of stocks, during various inflationary readings of the last 60 years.

A chart showing average annual returns of gold and commodities minus the returns of the S&P 500 following CPI inflation readings ranging from -1% to 13%.

The far-left bar in the chart, for example, shows that gold’s average annual return was 11% worse than the S&P 500’s annual return following CPI inflation readings below 1%. But the bar on the far-right side of the chart shows that gold delivered an average annual return that was nearly 75% higher than the S&P 500’s when CPI readings topped 11%.

Summing Up

On Monday, according to a CNBC article, Powell vowed to take “tough action” against inflation and promised that the Fed would “continue to hike rates until inflation comes under control, and could get even more aggressive than last week’s increase.”

But because we’ve yet to know what the future holds, building a modest position in gold might be a worthwhile insurance policy.

To dig deeper into this topic, check out my gold-focused article from last month, Gold Might Be the Asset of Yesteryears… Until the Market Looks Like It Does Now.

Regards,

Eric Fry
Editor, Smart Money

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On the date of publication, Eric Fry did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends… before they take off. In fact, Eric has recommended 41 different 1,000%+ stock market winners in his career. Plus, he beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today he’s revealing his next potential 1,000% winner for free, here.


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