Asking for a friend

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A reader asks: how do stockmarkets typically do in high inflation / interest rate rising environments (asking for a friend). You can see why the question is being asked:

It’s the question we’re all asking right now (or should be).

It’s funny sometimes when something that has been so widely predicted / talked about, actually comes to pass for once it doesn’t make it feel any less weird or alien.

Half of last year was spent talking about inflation, and while we’ve well and truly moved on from transitory, “inflation” is probably the least surprising contender for word of 2022.

I still feel we have incredibly little real data on how stockmarkets react to inflation, partly just because of how long it’s been since we had real inflation (all the way back to the 1970s, which is way before the start of most financial data series we tend to use) but also because of the subtlety of the real questions you need to ask: it’s not just high inflation, it’s rising vs falling, from a high base or low base. With or without interest rate rises, with or without high starting valuations. Historical data is far less useful than you might think at first blush which may be one reason the market has been all over the place this year, reacting to every twist and turn of Fed terminology and wording. The other reason that’s happened has to do with Vladimir Putin, but lets set that to one side.

The definitive stockmarket dataset is the Credit suisse yearbook and the 2021 authors were quite prescient in including this chart of stock and bond returns under different inflation regimes.

So no, stocks are not a “hedge” for inflation, but they do tend to do pretty decent under most inflation environments.

Of course “do pretty decent under most environments” hides a lot of detail under the surface, but as a long-term investor it is important to see the wood for the trees.

The exception to that is the very most inflationary environments where the cutoff appears to be annual inflation north of about 7% when real returns on stocks get more or less snuffed out.

Schroders look at it a different way – breaking inflation into four regimes (high / low and falling / rising) and rather that returns looking at the likelihood of assets outperforming inflation. This confirms that equities are pretty reliable for outperforming inflation, but highlights a weakness in the “high and rising” environment which is a difficult environment for a lot of assets. REITs could be interesting here.


Meanwhile, several commentators have reproduced similar analysis for rising interest rates (whether using actual Fed funds increases or 10-year yields)

From Ben Carlson’s blog:

So only the early 1970’s hiking cycle actually resulted in negative returns overall. while the mid 80’s and early 90’s versions had low returns. This table does group pretty long periods of time in together – which is probably what you want to do to see the wood for the trees as a long-term investor but it does hide a lot beneath the surface. It also highlights how few data points you really have to go on here.

Looking at it using increases in the 10 year yield rather than fed funds doesn’t really change the conclusions. Still seems to flag up the same periods of time as being problematic for stocks while supporting the overall average conclusions.

So the conclusions seem fairly straightforward:

Stocks aren’t a “hedge” for inflation, but they do tend to do pretty decent under most inflation environments. ditto rising rate environments.

Of course “do pretty decent under most environments” hides a lot of detail under the surface, but as a long-term investor it is important to see the wood for the trees.

Inflation north of about 7% is when real returns on stocks start to disappear.

That’s a hell of a lot better than the alternative though – bonds, who start to see pretty significant real losses mount up as soon as inflation gets much over 4%. And that doesn’t take into account starting yield levels. slap on a yield around today’s levels and you can be pretty sure the real returns are zero or negative for most bond classes, especially after fees as AQR show in their 2022 capital market assumptions.

Ok so the early conclusion here looks to be something like: stocks do fine, but you need to lower your expectations compared to historical returns, especially for a balanced portfolios with bonds in. So far so sensible, if unhelpful. Any more insights to offer?

Some other data sources offer a little more nuance. Meb Faber in his review of asset allocation also looks at data for emerging market stocks, small cap stocks and REITs, showing that in the inflationary period 1973-1981 emerging market and small cap in particular significantly outperformed large cap stocks. (I leave to one side gold and commodities as I just don’t think these are part of the conversation given their overall long-term returns).

It surprised me a little quite how starkly those two asset classes outpeformed in that period of time, not sure that’s focused on quite enough.

Another piece by AQR also tries to unpack the post 1990’s regime shift, but again highlights that emerging market currencies is one place you might want to be here. One surprise out of both of these analyses is that real estate (or REITs) don’t look better.

So if we are trying to draw out the relevant long-term allocator lessons from all this it looks like we ought to conclude:

We’re in a higher inflation environment and we need to reduce our expectations of real returns of stocks, and doubly so for bonds.

The uncomfortable conclusion: maybe you need to allocate more to stocks vs bonds than you think. The obituary of the 60/40 has been prematurely written many times, but it could really be coming, this time.

To hit a given real return hurdle, you need to allocate a lot more to stocks than what was the case a decade ago. The flipside of that is if you are in a balanced fund or gluidepath that was designed a decade ago, it might no longer work. chart below sourced from LCP, here.

What asset allocation do I need to return inflation +2% per annum, today vs a decade ago:

There are some lessons for asset allocation as well: allocate to emerging markets and small caps as part of your overall equity allocation strategy, and perhaps REITs as well.

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