Catching Up
In the first three posts in this series we looked at the correlation between various stock market investments and inflation. Part One looked at Large Cap stocks and Small Cap stocks. Part Two looked at Value stocks and Growth stocks. Part Three looked at gold, oil, corn and soybeans. Long story short? The broad markets and value stocks were negatively correlated with inflation, commodities were positively correlated with inflation, and growth stocks appeared to be positively correlated but the NASDAQ was such a different index in the late 70’s and early 80’s I am not sure we can place significant levels of confidence that the results apply to today.
Today, I thought we would grab the low hanging fruit and look bonds and bond alternatives to see how they correlate with inflation. Intuitively, the correlation should be profoundly negative, but we will see below.
Treasury Bonds
As we presumed, treasury bonds have a negative correlation with inflation.
If you don’t know much about bonds and how they act during the swings of financial cycles, here is an excerpt of an article by Thomas Kenny that explains it pretty well:
Bond prices and yields move in opposite directions, which you may find confusing if you’re new to bond investing. Bond prices and yields act like a seesaw: When bond yields go up, prices go down, and when bond yields go down, prices go up.
In other words, an upward change in the 10-year Treasury bond’s yield from 2.2% to 2.6% is a negative condition for the bond market, because the bond’s interest rate moves up when the bond market trends down. This happens largely because the bond market is driven by the supply and demand for investment money.
If investors are unwilling to spend money buying bonds, the price of them goes down and this makes interest rates rise.
When rates rise, that can attract those bond buyers back to the market, driving prices back up and rates back down. So conversely, a downward move in the bond’s interest rate from 2.6% down to 2.2% actually indicates positive market performance. You may ask why the relationship works this way, and there’s a simple answer: There is no free lunch in investing.
From the time bonds are issued until the date that they mature, they trade on the open market, where prices and yields continually change. As a result, yields converge to the point where investors are being paid approximately the same yield for the same level of risk.1
This prevents investors from being able to purchase a 10-year U.S. Treasury note with a yield to maturity of 8% when another one yields only 3%. It works this way for the same reason that a store cannot get its customers to pay $5 for a gallon of milk when the store across the street charges only $3.
When inflation goes up, interest rates go up as well. This happens on two fronts: (1) the Federal Reserve has historically raised overnight interest rates as inflation increased in an effort to slow down the economy and cool off inflation; and (2) bond market investors bids to purchase bonds drop so that their effective yield compensates them with a real return plus inflation (this is called the Spread).
I know that sounds confusing, so here is some additional explanation from Crestmont Research:
You can see from the chart above that the Spread is not a fixed number, which represents the give and take nature of the bond market. The easiest way to think about it is much like what happens when you go to an auction – sometimes buyers get a bargain and sometimes sellers make a killing.
So if we take the 2.20% average spread discussed above and add that to the CPI reported today at 4.20%, in theory long term treasury yields should be around 6.50% instead of 2.41%. Clearly, either yields are currently mispriced and we will see a significant increase in due course or investors in the bond market do not yet believe that the current level of inflation is sustainable. We will find out in time.
Corporate Bonds
No real surprise here – we have a material negative correlation between corporate bond returns and inflation, even more so than Treasury bonds. However, if you think about it, it should not be a surprise. Rising inflation hurts corporate profits, as not all increased costs of production inputs are or can be passed along to customers in the form of increased prices. That means the corporation issuing the bond is in less sound financial condition than they were prior to inflation increasing, which puts even more downward pressure on returns.
Utility Stocks
One of the ways that investors have been combatting low interest rates on their fixed income investments is to have invested in equity investments that pay high dividends. Utility stocks are one such equity investment, with an average current yield over 3% (and some utilities yielding over 5% – if not now then when they initially made the investment – much better than a 0.16% two-year Treasury Note).
Much like corporate bonds, there is a materially negative correlation between Utility stock returns and inflation. The concept of the corporation being in less sound financial shape due to inflation having additional downward pressure on returns applies to equity investments just the same as it does to fixed income investments, if not more so given that corporate bonds holders are higher on the liquidation ladder than stock holders in the event of a corporate bankruptcy.
Real Estate Investment Trusts (aka REITs)
This one is tricky. Real estate should go up in value during periods of inflation. However REITs are traded not on the value of the underlying real estate but rather by-and-large on the stream of income that can be generated from operating the real estate. This makes them more like Utility stocks than an investment in real estate as a hard asset, and it one of the reasons that it is difficult (but not impossible) to include an investment in real estate as a hard asset in a traditional investment portfolio of stocks and bonds.
The material negative correlation exists with REITs in the same way as Utility stocks.
Implications
Given that a typical portfolio is weighted 60% stocks and 40% bonds for most retired folks, during times of inflation you cannot rely upon the fixed income portion to offset declines in the equity portion. So what are investors to do? One thing to consider is having an allocation within the fixed income portion of the portfolio to US Treasury Inflation Protected Securities.
TIPS (Treasury Inflation Protected Securities)
They have only been around for 20 years or so, so the analysis below is actually of the iShares TIPS ETF which had data available back to 2021:
Even though the data is for a more recent time period than the 60’s-70’s-80’s, we do see a positive correlation between TIPS and inflation. Below is a sparse description of TIPS from the US Treasury website:
Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
TIPS are an accounting nightmare so most investors use ETF’s when possible to simplify the investment process.
As long as we are looking at ETF’s, a fairly new entrant into the space are the Floating Rate Bank Loan ETF’s.
Floating Rate Bank Loan ETF
We see a positive correlation between this ETF and inflation. However, I want to caution you from jumping into these – they are new and our data is only for the past ten years so there is no way to know how they would react over years of rising inflation. They are also extremely aggressive and the credit quality of the loans that make up the ETF’s can be dicey at times (there may be a reason a bank isn’t holding these loans on their books and instead are charging investors a management fee to oversee the portfolio within the ETF).
Whats Was Once Will Now Be Again
You may think this a crazy idea, but Cash Will Be King once again most likely. If we have a serious period of rising inflation, short-term rates will rise and investors will be able to invest in cash and get an actual return on it. Maybe the Federal Reserve will be forced to overnight rates or maybe they will deny inflation is present. It really doesn’t matter because the bond market will discount short-term bonds such that the yield will compensate the bond holders for inflation and provide a real return (see discussion above).
As a portfolio manager, we will focus on laddering short term bonds and CD’s so that we have a chance to reinvest them in ever higher yields…we just have to get to that point first.
What’s Next?
In coming posts in this series, we will look at individual companies within various economic sectors to see if we can get a feel for what sort of investments besides commodities, cash, and (potentially) growth stocks can safely make up a portfolio during rising inflation.
We have heard for years that you want to own Consumer Staples and Pharmaceutical companies during times of market turmoil and during times of inflation because these are companies that produce things we always have to buy and they have pricing power to pass along the rising costs to their consumers. That will be where we start so that we can see if this is true.
—Mark
