Investor Place: Watch Out for Inflation

Article by Eric Fry in Investor Place

“Gradual” is not synonymous with “irrelevant.” 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.

Gradual changes can produce surprisingly powerful effects over time. Clearly, a gradual shift is not an irrelevant one. In the world of finance, gradual changes are the ones that usually produce extraordinary success… or failure.

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.

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.

Earlier this week, when the U.S. Bureau of Labor Statistics announced that the CPI inflations reading for September hit the highest level since 1991, the gold price bounced a little on the news. But the stock market and bond market took turns yawning.

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 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%.

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.” 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 ......

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