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The Inflation Chess Game
Plus July Market Report

John Gorlow | Aug 12, 2021

Covid-19 remained the top story in July, with the fast-spreading Delta variant dashing hopes that life might soon return to “normal”. Meanwhile, global warming wreaked havoc across the world. Massive wildfires in the West spewed smoke across much of the United States. Record rainfall across Western Europe caused extensive flooding, destruction and death. Unprecedented heat and drought destroyed crops of summer fruit and produce. Despite these cascading catastrophes, July was a good month for investors.

It’s not that the markets ignored all the negative news. In one bad patch around mid-month, global stock prices tumbled more than 3% and bond market yields sank to a five-month low. But by the end of July, the S&P 500 had notched a 2.38% return, the sixth consecutive month of a positive showing for the index. July saw good news in the bond market too. Many expected bond prices to sink following a sharp 5.4% increase in the June CPI index. Bond prices typically decline and yields rise with higher inflation expectations. Instead, bond prices rallied, with Barclay’s US Government Bond Index returning 1.34% for the month.

What are bond prices signaling? Could it be that post-pandemic inflation fears are overblown? The upward tick in bond prices in late July could reflect the widely held but perhaps erroneous view that a temporary spike in inflation will fade once supply chain issues are ironed out. But what if the Fed were to raise interest rates at a time when supply chain bottlenecks in automobile and housing markets are driving up prices and eroding incomes? The result could ultimately lead to weaker demand. That could have the perverse effect of driving inflation too low, argues Greg Ip of the Wall Street Journal (21-July). To make the point, Ip points to the European Central Bank, which raised rates in 2008 in response to high oil prices. Such a tactic works to cool demand, IP argues, but is not an appropriate tool when the issue is restricted supply. “That rate hike was like kicking the economy when it was down,” reported the New Yorker a few years later (“Europe’s Big Mistake”, 5-September 2011).

Oaktree’s Howard Marks echoed Ip’s concern by pointing out that for many years now central bankers across the world have been unable to produce the 2% inflation target they want, despite huge budget deficits, quantitative easing, and low interest rates. “The truth is we know very little about inflation, including its causes and cures,” he writes (Financial Times, 10-August).

By maintaining high monetary buffers, the Fed has demonstrated that it is far more worried about economic sluggishness than it is about inflation. “Who’s to disagree with the Fed and insist it’s not (the right priority)?” asks Marks. And yet, that doesn’t make the risk of persistently high inflation any less real, he adds.

The central concern for investors, of course, is inflation’s negative impact on the purchasing power of their invested assets. The past three decades have been a period of relatively moderate inflation in the US, and yet the purchasing power of $1 shrank to 51.4 cents over that period. Inflation erodes wealth. The question is, can we shield ourselves? And a second question: Should we even try, knowing that the pathway of unexpected inflation is uncertain at best?

A Closer Look at Inflation-Fighting Strategies

Investors have traditionally looked to a few key strategies to outpace or hedge inflation. Chief among these is increasing allocations to assets with high expected real returns, namely equities. For most investors this would mean putting 65% to 70% of their portfolios into stocks. This level of equity allocation makes some investors uncomfortable, as it requires more exposure to market risk and potential downturns. A second technique is to hedge against inflation by investing in assets that move more closely with it. Inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS), are obvious candidates. And third, some have argued that investing in commodities and stocks in “inflation-sensitive” industries, such as the energy sector, may also be good hedges against inflation.

Which strategies have proven to be effective hedges against inflation? A study by DFA in July 2021 examined the relation between US inflation and the performance of global asset classes (including bonds, stocks, industry portfolios, factor premiums, commodities, and REITs), both over a long sample period (1927–2020) and over the most recent 30 years (1991–2020).1

In summary “Results confirm the potential of most asset classes to outpace inflation over the long term and suggest that for investors prioritizing the preservation of purchasing power, inflation-indexed securities may be a more appropriate inflation hedge than commonly suggested alternatives.”

The study advises investors considering alternatives to inflation-indexed securities to exercise caution. In the few cases where the correlations were reliably positive, such as for energy stocks and commodities, the assets’ returns were around 20 times as volatile as inflation and more than half of their nominal-return variance was unexplained by inflation. Hence, if an investor is seeking inflation protection to reduce the uncertainty around the real value of their future wealth, these assets may not accomplish this objective.1

Whether you are trying to outpace or hedge inflation, it is important to recognize that seeking to mitigate risk isn’t in itself risk-free. On the one hand, investing in TIPS may cause you to forgo the inflation risk premium and the growth potential offered by assets like equities. On the other hand, you may not have the risk tolerance needed to stomach greater exposure to downside volatility from a higher allocation to equities. The fact is, the right mix of assets for growth and hedging purposes ultimately depends on your goals and needs.

“Safety from risk can be exceedingly costly. As a cure, it is often worse than the disease,” writes Mark Spitznagel in the Financial Times (10-August). “The simple act of recognizing the long-term costs of risk mitigation strategies might be the most valuable and profitable thing any investor can focus on.” In other words, hold tight and don’t stress your strategy with protective barriers that may hurt you in the long run.

Concerned investors may want to broaden their perspective. At the moment, market sentiment is swinging between extremes, swayed by fears of inflation, slow growth, tighter money supply, and the spread of the highly contagious Covid Delta variant. It’s also summer, when the market is traditionally in the doldrums. All this noise can make us ignore the positive news. Consider what Blackrock’s Wei Li recently wrote in the Financial Times (July-29): “Hiring is picking up. The restart of economic activity is real and broadening out to Europe and Japan. It is evident so far that the Covid vaccines are proving effective, suggesting new virus strains will probably delay but not derail this restart. And the monetary responses to rising inflation are likely to be far more muted than in past crises and economic cycles.”

Socially, our long battle with Covid-19 has made us more resilient, and perhaps more thoughtful about our long-term goals. A new work-from-home (WFH) culture is emerging that will give many workers, and families, more freedom and time. It is impossible to know what comes next, including what will happen with inflation. But for most investors, sticking to a risk-appropriate strategy built on individual goals and timelines is the best way to protect assets and still sleep well at night.

Do you have questions about your asset allocation? Contact me. I am here to help.


John Gorlow
Cardiff Park Advisors
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760.284.5550 Fax

1 Dimensional Fund Advisors, “US Inflation and Global Asset Returns”, Wei Dai and Mamdouh Medhat, July 2021


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