Investors must learn to ride the cycle of inflation

Economists may disagree about what causes inflation. But investors have plenty of historical experience to draw on. In his view, rising prices lead to the large-scale destruction of paper wealth. Bondholders run the risk of being flattened. Even owners of real assets, such as stocks and property, can suffer huge losses. Finding a permanent shelter from the storm is not easy.

Following the 2008 crash, I spent several months with a colleague, Chris Wu, examining the experience of the 1970s. We think that conditions were ripe for another bout of inflation. As in that decade, real rates had turned negative, governments were running large deficits, and monetary reserves had grown rapidly. We are not right at the moment. Deflationary forces were more entrenched than we thought.

But now that inflation is at its four-decade peak on both sides of the Atlantic, the time has come to revisit that discarded project. What we found, unsurprisingly, is that long bonds were the worst performing asset class, losing value both as the purchasing power of money fell and as rates rose. In 1977-82, US 10-year bonds lost 44% in real terms. The bonds’ risk premium rose as investors demanded returns above the rate of inflation. Credit spreads increased in line with inflation.

Stocks, which represent claims on real assets, should not suffer a permanent loss of capital during inflationary periods. But in the 1970s, US valuations plummeted as P/E rose at the same time as long-term rates. Wall Street’s price-to-earnings ratio (based on 10-year average earnings) fell from 24 times in 1966 to less than 7 times in 1982. US real estate companies fared poorly, as rents failed to keep up. inflation and real estate investors demanded higher rates of return.

It wasn’t all bad news. While the S&P Composite 1500 lost 44% in real terms in the 1970s, stocks that were cheap relative to fundamentals offered positive real returns. There are several reasons why these so-called value stocks had such a triumphant decade. First, they started out cheap compared to the rest of the market. Second, their reasonable valuations were a sign that investors had low expectations, giving them a built-in margin of safety during that turbulent decade. Third, the high P/E ratios made them less sensitive to rising rates.

Commodities, one of the main components of the CPI, gave even more protection. The price of oil and gold increased more than fivefold during the decade. Miners, energy and coal producers offered big returns. Investors who stuck with cash also did surprisingly well. Avoiding losses when markets went down gave them the option of buying cheap assets. Those who kept their powder dry on the currencies of countries less prone to inflation, such as Switzerland and Germany, fared especially well.

So far this year, the markets have followed the manual of the seventies. Central banks have been slow to respond to the return of inflation, and rising prices have been a global phenomenon. Bond prices have fallen while the yield on US 10-year bonds has nearly doubled. Stock market performance confirms that valuations are likely to fall as inflation picks up. Value stocks have again outperformed. The price of oil has soared, and commodity values ​​are proving their inflation-fighting credentials. Investors who took refuge in cash at the beginning of the year are happy; currency speculators who bought Swiss francs are even more so.

What is the problem? As the graph of inflation since the late 1960s shows, it is a cyclical phenomenon. There were three different periods of increase in the CPI in the US: 1968-70, 73-75 and 78-80. Each started with an inflation surprise that prompted central banks to tighten monetary policy. Rising rates led to recession. After each inflation spike, the authorities lowered their guard, causing prices to skyrocket again. Inflation reached successively higher levels.

Investors, whose inflation expectations tend to be hindsight, were caught off guard by what is known as the cycle. stop go. The winners of the past are the losers of tomorrow. Commodities proved especially volatile, bubbling one moment and crashing the next. In the 1973-75 stock market crash, commodity stocks turned out to be more correlated with other stocks than with the price of the underlying materials. After inflation peaked, haven currencies lost their appeal and fell.

The current bout of inflation could prove even more cyclical. Central banks have printed more money and kept rates lower than they were five decades ago. There is no apparent end to the energy crisis. On the other hand, the assumption that rates would remain lower, longer it is deeply embedded in the financial architecture, making the system highly vulnerable to even a slight monetary tightening. With the world economy reeling under a mountain of debt, deflation remains a persistent threat.

The traditional approach buy and hold makes little sense in this environment. In the first half of the 1970s, many US investors’ benchmark portfolio – 60% stocks and 40% bonds – lost more than half its value in real terms. Today, US stocks are trading at much higher valuations and bond yields are much lower. To survive the turbulent times ahead, investors must learn to ride the cycle of inflation.