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Is Inflation Transitory?

June 3rd, 2021

What are the odds that the Fed is correct?

Below is a graph that I saw on an investment site I watch. It struck me that the current level of bond yields for the current level of inflation are so outside the norm and divergent from the mean that either the Federal Reserve is correct and the inflation we are seeing now is a temporary blip up OR we have investors betting on a big return based upon a low probability bet that could end very badly.

If you play the casino game craps, you know that it is all probability-based. You are betting that a number is or is not rolled before the number seven is rolled (seven being the number with the most combinations of the numbers on the dice – one and six, two and five, three and four, four and three, five and two, six and one – making it the highest probability of being rolled. The high probability bets are on the six and the eight since they have the second highest number of combinations. one less than seven. The odds are higher that you will win with a six and an eight, so your winnings are less when they hit. The big money is made betting on two, three, eleven and twelve as the combinations are limited so the odds that they are rolled before a seven are much smaller.

When I look at the chart above, the current plot point shown in red and labeled as such is so far from the mean (as represented by the red line) that its like betting on two or twelve, which are known as the sucker’s bets since the house’s odds of winning are so high that these are the numbers the house encourages you to bet on.

There is an economic concept called Yield Curve Control. Yield Curve Control is a process by which the Federal Reserve buys so many bonds with longer maturities that it keeps yields from rising – it’s simply our old friend supply and demand coming into play. The Fed provides more demand than the required supply so the treasury has no need to issue bonds at higher yields to fund the government. Since the 2008-2009 financial crisis, the Fed has been buying bonds as a way to increase the money supply and thereby stimulate the economy (we’ve written about this Quantitative Easing process on the blog in the past).

So what happens if the artificial demand from the Fed slows down? We can look back to 2013 because the Fed tried to do exactly that thing and it caused them a problem that has become known at the Taper Tantrum in the bond markets. The ten year treasury bond yield roughly double over a three month period in Spring 2013 when the Fed began to slow its purchases of bonds – ie., the demand dropped below the supply required to fund the government so the yield had to rise to entice people to buy the bonds. Before any major damage was done to the economy from the abrupt rise in yields, they resumed buying bonds at the previous level.

In recent statements from the Federal Reserve, certain members of its board have come out with statements saying that the Fed would need to start tapering in the future to ease up on the monetary stimulus that is helping to fuel the rise in inflation. This week, the Fed announced that they would begin to sell off the corporate bonds they purchased last year during the covid recession. Tapering seems to be real, even if it is beginning slowly with the sale of the small number of corporate bonds they own.

Going back to our craps analogy, in the world of economics and bond yields, it appears that the Federal Reserve is the house and they are encouraging you to buy bonds at low yields by saying that inflation is transitory. The big question is whether the bet to buy a ten-year treasury is betting on the six or betting on the twelve, and whether rolling a seven with inflation being higher for longer hits sooner rather than later.

—Mark

Investing During Inflation (Last In Series)

May 21st, 2021

Where We Are

This has been a rather exhaustive series on which asset types have a historically positive or negative correlation with inflationary periods in our economy.

Here Is What We Learned

  • Broad market investments: over the periods of time examined, the S&P 500 (Large Cap Stocks) and S&P 600 (Small Cap Stocks) were negatively correlated with inflation. This does not bode well for the people who have bought into the theory that investing in an index fund like the S&P 500 is a safe and good choice at all times
  • Value Stocks: over the periods of time examined, the Dow Jones Industrial Average was negatively correlated with inflation
  • Growth Stocks: over the periods of time examined, the NASDAQ was positively correlated with inflation – but we did note that the NASDAQ Index of the 70’s and 80’s is a materially different index than the one we have today, so this positive correlation should be viewed cautiously
  • Gold, Oil & Agricultural Commodities: we saw a positive historic correlation between inflation and these commodities – we did note that the rising price of oil due to supply/demand imbalances is a leading cause of inflation that drives prices higher across the board
  • Fixed Income and Fixed Income Alternatives: as expected, fixed income and its alternatives showed decisively negative correlation with inflation – however, we examined both Treasury Inflation Protected Securities and Floating Rate Loan ETF’s which showed positive correlation but cautioned that the data on the latter is too new and limited to really draw solid conclusions
  • Consumer Staples: given the pricing power that consumer staples companies have used to pass along their increased costs of production to consumers, we were surprised to find that there is a negative historic correlation between their returns and inflation – we noted that could be any number of mitigating factors that keep them from passing along all or even a material amount of their own cost increases, which might be the cause of the negative correlation
  • Financials: again we were surprised to find a negative correlation between the returns on bank stocks and inflation since inflation generally results in rising interest rates which have a positive impact on bank margins and net income – we noted that this may be a case where early in the rising inflation cycle, the rising rates would have a positive impact but that later in the cycle when rates are elevated credit quality issues might come into play and negatively impact net income
  • Health Care: a common perception is that Health Care companies can raise their prices to offset increased costs of production, making them a good investment during times of inflation, and that is exactly what we found with positive correlations between drug, supply and device company returns and inflation
  • Industrials: we found a mixed bag when we examined industrial companies, with some having positive correlations and some having negative correlations – our assumption is that there are industries in the Industrial Sector that have pricing power and others that don’t, and since many of the largest industrials are conglomerates that operate in multiple industries, their correlations are really dependent upon the mix of industries in which they operate
  • Consumer Discretionary: again we found a mixed bag with some companies showing a negative correlation and some a positive correlation – our assumption again that certain companies have competitive advantages that give them pricing power whereas others do not

Implications

In the April 30th post titled Prices On The Rise ( http://investmentblog.bankchampaign.com/2021/04/30/prices-on-the-rise/(opens in a new tab) ) I showed you a number of instances where corporations made statements about having to raise prices due to their costs of production increasing. Since then, we had reports of steeply increased consumer and producer inflation with the CPI and PPI reports last week. Also, at the most recent Berkshire Hathaway annual meeting, Warren Buffet noted that his companies were raising prices due to their own costs going up.

Inflation appears to be here and hitting all aspects of the economy, At the present time, the Federal Reserve is stating that the inflation is transitory and will be gone in a few months so they have no intention of tightening monetary policy. We also know that the government is planning on historic levels of fiscal policy spending. The combination of announced easy monetary and fiscal policy to me means inflation will likely not be transitory, but will lead to a permanently higher level of prices.

Before we plateau at that higher level, we will see inflation driving up those prices to that plateau and we need to have investment portfolios structured so that they perform as best as possible.

A winning investment strategy for stock portfolios would appear to be focusing on: (1) blue chips in the health care, energy, agriculture and materials sectors; (2) selectively on companies with pricing power in the industrials, discretionary and financial sector; (3) gold miners; (4) real estate (but not the fixed income alternative REITs); and (5) growth stocks with secular earnings growth fundamentals and perceived dominance for the future.

A defensive strategy for fixed income portfolios would appear to be: (1) a laddered portfolio of bonds and certificates of deposit that will have frequent and sequential maturities that allow for reinvestment at rising rates during an inflationary period; (2) an allocation to Treasury Inflation Protected Securities through a mutual fund or ETF; (3) short duration high quality fixed income mutual funds; and (4) an allocation to variable rate corporate fixed income ETF’s as long as credit quality is maintained.

What’s Next

I mentioned above the concept of prices rising until we plateau at a higher level. I hope to work on a blog post about that in the near future.

—Mark

Investing During Inflation (Part Nine)

May 21st, 2021

Previously

This has been a series of posts analyzing investment returns and whether they are positively or negatively correlated with inflation.

The final economic sector we are examining is Consumer Discretionary companies.

Walt Disney

Negative correlation

Whirlpool

Negative correlation

VF Corp

Negative correlation

However…

Comcast

Positive correlation

Southwest Airlines

Positive correlation

Implications

Much as we saw in the Industrials sector, we have a mixed bag in looking at Consumer Discretionary sector company results correlation with inflation. More analysis is needed but it may be company specific factors – cable television being a limited to a few major players in the early 80’s and Southwest being a disrupter of airlines with its economy flight business model.

What’s Next

In the next post in this series, I will give you my thoughts on how all of this data can be used to develop an investment portfolio that should weather the coming inflation and provide acceptable market beating returns.

—Mark

Investing During Inflation (Part Eight)

May 20th, 2021

The First Seven Parts

In the previous parts to this series, we looked at various investments to see how their returns correlated with inflation. We found some that were positive and some that were negative.

Today, we are going to see how companies’ returns in the Industrial sectors correlate.

Industrials

As you will see in the graphs below, there is positive correlation between the returns of some companies in the Industrials sector and inflation, yet there is a negative correlation between others. This very much surprised me when I did the research as I thought all would be negative.

Honeywell

Positive correlation

General Dynamics

Positive correlation.

Union Pacific

Positive correlation

MMM

Negative correlation

United Technologies

Negative correlation

Implications

Given the mixed results within the Industrials sector, It seems as though investors need to go company by company to determine whether they are appealing for investment during times of inflation. Part of the issue might be that so many of the companies in the Industrials sector are conglomerates that span multiple industries, some of which may have positive correlations and others which have negative correlations. General Dynamics is a mostly pure play on the Defense industry and it showed positive correlation while United Technologies exposure to the Defense industry is significantly smaller and showed negative correlation. I think a much deeper analysis is required to figure out which Industries within the Industrials sector are positive correlated before any conclusions are drawn.

What’s Next

I had originally hoped to write about both Industrials and Consumer Discretionary correlations in this post, but the conflicting results in the analysis of Industrials sent me down a rabbit hole of analysis so Consumer Discretionary comes in the next post.

—Mark

Investing During Inflation (Part Seven)

May 19th, 2021

Catching Up

This series has been about finding the various investments whose returns have a positive correlation with inflation. We have found that most have a negative return during inflationary periods, but that there are certain things that have historically shown that they have returns that are positively correlated with inflation.

Today, we are looking at the Health Care sector. It is widely believed that Heath Care stocks have the ability to raise prices and keep their clients, even during times of rising inflation. So, below are a few companies representing different industries within the sector.

Pfizer, Inc.

Positive correlation

Baxter International

Positive correlation

Medtronic, PLC

Positive correlation

Implications

The Health Care inflation we have all seen over the years may be one of the reasons for the positive correlation between Health Care company returns and inflation. Given that Health Care inflation seems to be persistent and present even during times of otherwise low inflation may be skewing these results. However, we see the positive positive correlation in pharmaceutical returns, medical supply returns, and medical device returns with inflation, so we cannot justify away the relationship based upon the persistent sector inflation.

What’s Next

The next post will be the final one in this series, unless I start writing and it looks like it will be too long and involved, then there will be two more. In this(these) final post(s) I want to look at the remaining sectors – Industrials and Consumer Discretionary – plus summarize my thoughts on how a portfolio needs to be structured to perform during inflationary periods.

—Mark

Investing During Inflation (Part Six)

May 18th, 2021

To Date

In the first five parts of this series, we looked at the correlation between investment returns and inflation, determining which investments had positive correlation and which had negative correlation. Most were negative, some surprisingly so, but there were most definitely some with positive returns during times of inflation.

Today, we are going to look at financials since intuitively banks make more money when interest rates are rising because their net interest margin expands, and interest rates historically have risen during periods of inflation. So, we would expect to see positive correlation between banks and inflation.

JPMorgan Chase

Negative correlation.

Bank of America

Negative correlation.

Implications

I don’t want to bore you with another series of graphs showing the same correlation pattern, but it exists.

I think what we see is that the intuitive pattern of rising inflation leading to rising interest rates leading to higher bank earnings exists – but only up to a point. There comes a point, if you recall the conversation we had on corporate bonds earlier in this series, where the financial health or corporate borrowers overcomes the benefit of higher rates and earnings fall due to defaults.

Up Next

Much like Consumer Staples companies that are believed to have pricing power to pass along their own rising costs of production to consumers, Health Care companies are believed to have that advantage as well. In the next post, we will look at various industries within the Health Care sector to determine if there is a positive or negative correlation between their returns and inflation.

—Mark

Investing During Inflation (Part Five)

May 17th, 2021

Where We Left Off

If you have been following this series, you have seen a series of investment returns and their correlation with inflation, either positive or negative (most have been negative). In Part Four, I noted that we would next take a look at Consumer Staples companies’ returns since they are widely believed to be a safe haven during inflation because they have pricing power on items that you have to buy no matter what, and can pass along increases in the cost of production to consumers, they are insulated from negative correlation. Below are a series of companies and their correlation graphs.

Procter & Gamble

Definitely a negative correlation for this maker of stuff we have to use everyday.

Coca Cola Co

Definitely a negative correlation for this maker of one of the world’s favorite beverages.

Kellog Co

Definitely a negative correlation with this cereal and packaged food giant.

Molson Coors

Definitely a negative correlation for this leading beer producer.

Implications

Looking at the data, it certainly does not appear that Consumers Staples companies are a safe investment during times of inflation. There are a number of reasons why the data could be skewed (e.g., the impact of mergers and acquisitions, impact of accounting rule changes, financial health of the consumer, consumers’ substitution of generic and store brands for higher priced name brands, etc.) and that this time it could be different. However, given what we see in the data, caution seems to be warranted.

What’s Next

Financials seem to be a good place to move for the next analysis. Higher inflation has historically led to higher interest rates, which are positive for banks’ net interest margin and bottom line earnings. Intuitively, we would expect to see a positive correlation between banks’ returns and inflation. Given that intuitively we expected to see a positive correlation between Consumer Staples and inflation given their pricing power over goods we must buy, it will be instructive to see how it plays out.

—Mark

Investing During Inflation (Part Four)

May 12th, 2021

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

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