Last week, I looked at some of the investor concerns about inflation, noting that inflation expectations had jumped recently (you can read the full article here).
As the economy comes out of the covid-induced recession, the government is still responding aggressively, which has some investors concerned that there will be too much money chasing too few goods, leading to higher prices.
This week, I promised to describe some of the actions that our Investment Committee has talked about in recent months in response to the potential for higher prices.
Treasury Inflation-Protected Securities (TIPs)
TIPs are issued by the US Treasury and have the full faith and credit of the US government. Unlike normal Treasury bonds, the principal is adjusted based on changes in the Consumer Price Index (CPI).
Seems like a no-brainer, right? Like most things, the answer is… sort of.
We’ve owned TIPs before as part of our diversified bond portfolio but exited in 2016-2017 because we observed that they were more volatile than they ‘should’ be and that they were more sensitive to interest rates than they had been in the past.
We felt like the risk/return balance wasn’t right and you can find a detailed write-up on page four of the January 2017 edition of Portfolio Insights in the article ‘TIPs behaving badly.’
Right now, our concern is a little different. Given the old adage that there is no such thing as a free lunch, TIPs only fair better than nominal bonds when inflation comes in higher than expected. Right now, the market expects inflation to be around three percent in the next two years, and around two percent over the next decade.
For TIPs to fare better than regular bonds, the market would have to be ‘surprised,’ and given that the Fed has been unable to get inflation to its target of two percent for the past several years, three percent would indeed be surprising.
Another way to say it is that our regular old nominal, not specifically inflation-protected bond portfolio should probably do the trick.
Gold is a perennial favorite for people worried about inflation. I think that’s because, over the very long arc of history, it protected people whose country or currency collapsed.
And there are anecdotes of how an ounce of gold bought a fine men’s suit in Mesopotamia 10,000 years ago and still does today. (Although at 1,700 an ounce, it will get you two suits a Brooks Brothers, and between three and 12 suits at Joseph A. Banks!)
And, of course, gold has fared well in many periods of stress (though not all). I’ll update my piece on gold in the not-too-distant future, but this article (click here) sums it up pretty well: gold is extremely volatile, especially when compared to inflation. In my view, it seems akin to using a chainsaw to clip your fingernails.
That said, we know from modern portfolio theory that an asset that’s volatile individually may not increase the volatility of the portfolio if the correlation is low. That’s true with gold, so I’m not as opposed to it as I used to be, I just don’t think it’s great protection.
I’ve written several times before that we dodged a real bullet with commodities. We talked about adding them as an asset class in 2007-2008 when they were on the upswing and a lot of clients were asking for them. Ultimately, we didn’t do it, and the prices collapsed almost immediately and haven’t done much since then.
I wrote about them more recently in 2020 (click here for the article) and show that, like gold, commodities are extremely volatile, which hardly makes for a good hedge against inflation, which is generally pretty stable (even when rising, or high).
Don’t even get me started. Okay, maybe just for a minute since everyone talked about it. The argument for bitcoin is that it’s not tied to a government, like gold. As a result, you don’t have to worry about the government printing too much money and sparking inflation.
But if you don’t like the volatility of gold or commodities (like I don’t), then there’s nothing to talk about with bitcoin since bitcoin’s volatility makes everything else look like child’s play.
I also suffer from the idea that bitcoin is entirely made up. Yes, you can say the same thing about the dollar, the euro, and why we put a value on gold versus some other shiny metal, and that’s true. But at least we’ve agreed on those things a little bit longer.
I’ve missed a big rally in bitcoin, having first learned about it when it was less than $500 and I almost bought some for $3,000 at a movie-theater vending machine. I decided that would make movie night pretty expensive, but a year later when I went back to the theater, it was $16,000 or so, which meant that it cost me $13,000 by not buying it (and much more now).
Bitcoin may not face the risk of money-printing politicians, but it faces plenty of other risks. I’ve read about people who forgot their passwords and can’t access their bitcoins. The bitcoin system seems to me to be a little like banking in the Wild West when you had to worry about train robbers, shootouts at high noon, and dynamite on the vault door.
We’ve been looking at all of these things for years and have concluded that they don’t make sense. Indeed, the best option historically for beating inflation is a mix of cash and bonds.
Right now, by keeping the yield on cash at zero, the Fed is taking away the cash option. Cash worked just fine in the 1970s, but today is different. Bonds have worked well historically, but with rates so low, they may not work well this time either.
The stock market works well against inflation, as long as it’s slow-moving and the market can price-in the new expectations over time. When there is a shock, like the oil embargo, they don’t help much.
All of the strategies that I discussed above will have their days in the sun, but they’re all imperfect enough that we don’t think they make sense right now. We may change our minds at some point, but today, it’s not even clear that real inflation is ahead.
As always, we’ll keep looking at the prospects for inflation, the markets, the available options and do our best to make informed decisions about how to protect investors from anything that we might face. So far, so good given that we’ve successfully navigated with two major crashes, 9/11 and a global pandemic in the life of our firm.