Current market speculation is that the Federal Reserve will raise rates to keep the inflation genie in the bottle. Or not. Deflationary forces such as a strong dollar, weak commodity prices, and stagnant wage growth are prevalent. Economists are divided: are undetected inflationary pressures building? Or are we in the midst of a debt-ridden, demographic-driven, and technology-enabled deflationary spiral? What risks do these contrasting forces pose for the value of your assets?
Fiscal Stimulus Can Help
Government monetary and fiscal policies can work to incent consumers and businesses to borrow, invest, or consume. Fiscal policy has been missing in action due to political posturing, while monetary policy has been guided by a fear of deflation. Monetary stimulus, however, (low interest rates and quantitative easing) has limits; it encourages indebtedness, consumption, and drives capital toward more risky assets like the stock market. This trend has been in place since 2009. Savers and retirees on fixed incomes are penalized by low returns and have difficulty maintaining their living standards.
Deflation occurs when business and consumers delay investment and purchase decisions. Rates remain low to try and stimulate demand for money. Once price deflation sets in, it is very hard for government policies to induce change. Cash and bonds become more valuable as prices decline. If consumers anticipate further price declines, they will delay purchases and thereby further weaken the economic environment.
Inflation occurs when there is an oversupply of money which drives the price of goods and services higher. If these prices grow faster than your income and assets, your purchasing power and living standards will decrease. Since World War II, inflation has been the biggest risk for financial assets over short time periods. Over longer time horizons stocks, real estate, and commodities are assets that, historically, help your money to grow faster than inflation.
Deflation has not been a problem in the United States since the Great Depression. However, there is legitimate concern that the economy is fighting this force. Japan has been fighting deflation for many years. Europe may also be on the verge. As noted, there is no consensus. With rates already at very low levels, there isn’t much more bankers can do to stimulate. Long term market rates are determined by the supply and demand for money, but even as the economy has recovered rates have declined. As noted, on the fiscal front our politicians are more concerned with being self-serving than civil-serving.
How do Assets Perform during Inflation and Deflation?
History gives us some guidance on this question. According to Global Financial Data, in the 19th century inflation averaged a meager 0.06% vs. a long-term average of 3%. Deflation was the biggest risk to US financial assets. Stocks outperformed bonds by only 0.3%; interest rates began the century at 6% and ended near 4%.
In the 20th century, inflation was the bigger risk for asset prices. Stocks outperformed bonds by 5.5%. However, from 1939-69, stocks outperformed bonds by 9.8%; between 1969-2001 stocks only outperformed bonds by 2.7%. That is a large shift in risk appetite.
In the 21st century thus far, Interest rates are at multi-decade lows. Inflation has remained well below historic levels particularly since the Great Recession. Bonds outperformed stocks from 2000-09 by about 4.9%. From 2010-2014, stocks have outperformed bonds by almost 12.8%. History shows that the appetite for risk can change very quickly and that it can last for very long. How to plan?
*Risk Premium is the amount that investors are willing to pay for stock over the risk-free rate of bonds. Source: Morningstar, Ibbotson (CAGR denotes compound annual growth rates)
Trying to predict short-term outcomes in financial markets is a losing game. Listen to CNBC for an hour and your head will spin listening to prognosticators pretend that their crystal ball has 20-20 foresight. Economic policies can further distort market functions over short time periods. The table below presents a reasonable view of how you might expect assets to behave during bouts of deflation and inflation. The table also makes the case for why we diversify your money across different asset classes.
|Stocks||Depends on magnitude||Positive over long periods|
|Real Estate||Negative||Positive over long time periods|
|Commodities||Negative||Positive over long time periods|
Stocks: generate the vital component of capitalism: corporate profits. Think about it. If you run a company and you begin paying more money for labor, supplies, and services you will need to raise prices to maintain your profits. This is why owning stocks helps to preserve your purchasing power. In the short-term: stocks decline when rates rise as investors sell off stock to buy bonds that now pay a higher rate of interest. Stock price fluctuations need to be balanced with your time horizon.
REITs: Real estate assets have also increased more than inflation. Rents from properties likewise increase over time. A good portion of your return comes from this rental income. In the short-term: a rate rise increases their cost of debt and can work against the price of these assets. Still, the income generation should increase over time as rates rise.
Commodities: these assets are a pure hedge against inflation. They move with supply and demand.
Bonds: provide income and stability. However, when rates rise, the price of bonds decline. In low rate environments it is possible to lose money.
Investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with some investments. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. Please see the Disclosure link at the bottom of the page for more detail at www.compoundvalue.com/disclosure/.