The Inflation Threat

All inflation indicators have ticked up recently.  The cost of living is rising faster than we have seen for at least ten years.  The authorities in Washington – most notably Federal Reserve Board (Fed) Chairman Jerome Powell and Treasury Secretary Janet Yellen – have downplayed concerns over this news, saying the price pressure is “transitory.”  They may be correct, though it would help reassure the investing public if they offered their reasons for this relatively rosy view. If they are wrong, and the economy suffers more inflationary pressure, the investment implications would be profound.  Investors then would do well to pare back on their bond holdings –– stocks, too, but mostly bonds –– and seek a greater position in “real assets” ––  especially real estate.  A looming inflationary prospect would also recommend borrowing for those who could support the additional cash-flow burden of a loan, especially if it is fixed at today’s low rates.

As of the date of this posting, the inflation news is far from encouraging.  According to the U.S. Dept. of Labor, consumer prices this year have risen at an annual rate of 6.6 percent –– quite a change from the 0.2 percent inflation rate averaged in 2020 and from the 1.5 percent annual average of the prior five years, 2015-19.  The department’s producer price index so far this year has accelerated to a 10.5 percent annual rate of advance, following an outright decline averaged in 2020 and hardly any inflation at all in the prior five years.  Other inflation indicators, such as the array of price deflators (a measure of the level of prices of all new, domestically produced, final goods and services in an economy in a year) tracked by the Commerce Department, show a similar pattern, while commodity prices – building materials, metals, oil, and even foodstuffs – have also shown a pronounced jump.

Bond investments are most vulnerable to the prospect of ongoing inflation.  Yields today are low.  The 10-year Treasury bond pays barely 1.7 percent a year; quality corporate bonds pay only a little more.  If inflation continues at its recent rate, current bond yields would mean that bond investors will lose in real terms.  At 4.5 percent inflation, for example, today’s Treasury bond holder would lose 2.8 percent a year to the rising cost of living –– hardly a good investment.  If such losses were to continue, investors would sell some or all of their bond holdings, depressing prices and raising yields as explained in this post.  Such an exodus from bonds would continue until yields rose high enough to more than compensate investors for the rising cost of living.  

In such an inflationary environment, stocks would also suffer, especially at first.  The accelerating rate of inflation would make current dividend yields less attractive, convincing some investors to sell.  And as bond yields rose, they would regain some of their appeal and prompt other investors to sell stocks and buy bonds; stock prices would suffer accordingly.  But in the longer run, corporate profits would rise along with the general rate of inflation and restore some of the attractiveness of stocks (as explained in this post, but the stock recovery would take time.

In an ongoing inflationary scenario, real assets would become more attractive.  Real estate is an obvious choice, but there are also alternatives, such as art, antiques, classic cars, and the like.  Anything that holds its real value would rise more or less in tandem with the cost of living.  Furthermore, because investors would flock to such assets, history shows that in times of high inflation they tend to gain value more quickly than the rising cost of living.  Before bond yields and interest rates rise to adjust to the higher rates of inflation, investors might also do well to leverage their purchases of real assets –– that is, go into debt to buy, as in mortgaging a house.  Before doing so, however, investors should assess whether they could comfortably service such a loan, because failing to do so would certainly unwind any of the investment benefits of buying real assets.  Investors who lack the resources for additional purchases of real estate might consider real estate investment trusts (REITs) as a way to gain exposure to real assets.  Learn about them in this post  and this one.