Inflation and investments

[Simpo Two]

For all the time I've taken investing seriously - and living on investments for the last eight years - inflation has been very low. Hence it was easy to see how the average investment would beat inflation and so you'd get richer in real terms. In simple terms, inflation = 1%, investment growth 6% = you are 5% better off.

Now inflation has rocketed for various reasons and investments are generally going down. So in simple terms we now have: inflation 10%, investment growth -3% = you are 13% worse off.

What I can't resolve is whether the value of investments has inflation 'built in'. For example, if everything is going up thanks to inflation by 10%, does it mean that the underlying price of what you're invested in is also on the same escalator, ie going up by 10%, and only the perceived value of the investment is falling?

If not, then to beat inflation in real terms (ie get richer) your investments will need to rise by more than 10% and I don't see the average sensible portfolio doing that. So what did investors do to get ahead when inflation was this high last time?

[Vanity Projects]

We’re heading for an interesting time, inflation running so hot suggests little will keep pace.
Stocks have had a stellar few years (SP500) because governments have been printing money like mad but that is about to dry up so I doubt stocks will keep pace this cycle.

At such high rates Corporate bonds is f gvt bonds won’t pay that premium so it only leaves physical stuff.

There’s a very detailed paper here that explains the likely returns by asset class

https://papers.ssrn.com/abstract=3813202

Basically,

Oil and Energy commodities
Metals commodity
Gold
Real Assets (Bricks/Mortar)
———
Everything else under the 10% line

[Derek Chevalier]

Simpo Two said:

So what did investors do to get ahead when inflation was this high last time?

I'm not sure what "getting ahead" means, but for a well-diversified global portfolio, there shouldn't be any need for a change.

[Derek Chevalier]

Vanity Projects said:

Stocks have had a stellar few years (SP500)

There are more markets than just the S&P. Emerging markets and developed small-cap value returns have been much more subdued and hence have lower valuations.

A robust portfolio, using an approach similar to this will help you find a solution that is best place to work over the long term.

https://www.amazon.co.uk/Smarter-Investing-3rd-edn...

[Simpo Two]

Derek Chevalier said:

Simpo Two said:

So what did investors do to get ahead when inflation was this high last time?

I'm not sure what "getting ahead" means, but for a well-diversified global portfolio, there shouldn't be any need for a change.

Better off as opposed to worse off.

I intend to stay put, partly because I don't have the confidence/knowledge to dismantle a portfolio that has done well, and partly because I think the time to do it for best results was then and not now.

The question that remains unanswered though is 'What I can't resolve is whether the value of investments has inflation 'built in'. For example, if everything is going up thanks to inflation by 10%, does it mean that the underlying price of what you're invested in is also on the same escalator, ie going up by 10%, and only the perceived value of the investment is falling?'

[Derek Chevalier]

Simpo Two said:

The question that remains unanswered though is 'What I can't resolve is whether the value of investments has inflation 'built in'. For example, if everything is going up thanks to inflation by 10%, does it mean that the underlying price of what you're invested in is also on the same escalator, ie going up by 10%, and only the perceived value of the investment is falling?'

If you are talking about the broad indices, e.g. FTSE 100, S&P 500 etc, then no, there is no adjustment for inflation. So if (in rough terms), the S&P falls by 10% in a given year, inflation is up by 10%, your portfolio is 20% worse off in real terms.

You will often see long term returns described as real returns

https://www.credit-suisse.com/about-us-news/en/art...

"Equities have performed best over the long-run. Over the last 122 years, global equities have provided an annualized real USD return of 5.3% versus 2.0% for bonds and 0.7% for bills."

This is adjusted for inflation

[vulture1]

Simpo Two said:

The question that remains unanswered though is 'What I can't resolve is whether the value of investments has inflation 'built in'. For example, if everything is going up thanks to inflation by 10%, does it mean that the underlying price of what you're invested in is also on the same escalator, ie going up by 10%, and only the perceived value of the investment is falling?'

The share has already gone up based on the expected inflation. So for me I bought PepsiCo last march at $130. It was at a dip and has since risen up to $165. However since then inflation in their transport costs, cost of cans plastic, crisps, cereal etc have all gone up. But they had said they will pass that on to the consumer. Most of these products are inelastic. Ie demand stays the same regardless of price. So next year they will sell the same number of units at a higher cost and higher price so revenue and profits are both bigger numbers thus making the higher stock price look justified.

Same with oil.

Edited by vulture1 on Saturday 5th March 19:30

[Simpo Two]

Interesting. So an individual stock can have inflation 'built in' (vulture1) but not a whole index (Derek). As an index is made up of many stocks, it must mean that some are (relatively) inflation-proof and others not, is that right?

[Jon39]

Simpo Two said:

.... So what did investors do to get ahead when inflation was this high last time?

You have to hope that you have holdings in businesses, that can pass on inflationary price increases to their customers.

Water companies are well placed.
Tobacco sector - customers tend to be very loyal (addicted).
Food - a hugely competitive sector, but I suppose we have to eat.

Not so easy for manufacturers / sellers of discretionary products, because customers can put off purchases.

Each sector will have varying circumstances.

During times of higher inflation, the stock market returns were on average higher. My portfolio from 1988 to now, had an annual average rate that peaked a few years back at +14%, but this figure has been reducing for several years now, because interest rates and inflation has been so low (interest rates were running at 300 year historic lows) particularly since 2008 until recently.




If you want to, the way you can be warned if significant changes of direction in inflation, is to note the published RPI figures, then graph the last 12 month; and last 6 months times 2. Your 6 month times 2 line will move direction in advance of the 12 months, when a significant change is occurring.

Oçasionally the 12 months inflation figure can be misleading, caused by a particular month (which might have had a big jump or a negative move) dropping out of the review period. Can be quite funny when the BBC TV News reader tells us, inflation is up this month because of XYZ. Whilst throwing something at the screen, you say, "No it is not, it is only because the significant figure from 13 months ago, has dropped out of the calculation". ~

We have to hope not to have a repeat of the 1970s, when inflation peaked at 25%. That began with huge increase in oil prices. Ooops

Edited by Jon39 on Saturday 5th March 23:18

[Simpo Two]

Jon39 said:

You have to hope that you have holdings in businesses, that can pass on inflationary price increases to their customers.

Water companies are well placed.
Tobacco sector - customers tend to be very loyal (addicted).
Food - a hugely competitive sector, but I suppose we have to eat.

Not so easy for manufacturers / sellers of discretionary products, because customers can put off purchases.

Thanks, makes perfect sense. I'm more of a funds person than a shares person, but I'm not sure what fund category would include water, fags and food. Does oil have legs?

[LooneyTunes]

Simpo Two said:

Interesting. So an individual stock can have inflation 'built in' (vulture1) but not a whole index (Derek). As an index is made up of many stocks, it must mean that some are (relatively) inflation-proof and others not, is that right?

I think people may be perceiving the question/answer differently.

If inflation is running at 10% and you buy a stock today for 100p, you need it to be 110p in a years time to have kept up with inflation.

Intrinsic value of companies and their share price are not always as tightly linked as some would suggest. Sentiment plays a significant role (especially for retail investors), as does (or at least should) sensible analysis of factors directly/indirectly impacting the company and its operating environment both today and into the future.

There are some stocks where, as has been said, there is tremendous in elasticity of demand within their market and their fundamentals are sound but others where the bias seems to be more sentiment driven with price based on future expectations (that may or may not have a solid rationale supporting them - think dot com days!).

You could argue that it doesn’t really matter what drives a change in share prices but what does matter is that to keep up with inflation you need to be able to do as much with your money at a future point in time (by selling your shares/through a combination or sale and dividend) as you can today in order to have kept up.

Within an index you have a mixture of stocks, each of which will perform differently in an inflationary environment. The index won’t deliver the best overall performance, but neither will it deliver at the level of the worst performers.

[mike74]

I've rapidly arrived at the conclusion that the notion that "investing in equities is a hedge against inflation" is a actually a huge pile of steaming horse st.

[Simpo Two]

LooneyTunes said:

You could argue that it doesn’t really matter what drives a change in share prices but what does matter is that to keep up with inflation you need to be able to do as much with your money at a future point in time (by selling your shares/through a combination or sale and dividend) as you can today in order to have kept up.

Agreed.

LooneyTunes said:

Within an index you have a mixture of stocks, each of which will perform differently in an inflationary environment. The index won’t deliver the best overall performance, but neither will it deliver at the level of the worst performers.

Indeed. So what we need to invest in now is that part of the index that will perform well in times of high inflation. But rather than make my own picks, as I'm not expert enough, I'd pay a fund manager to do that bit and present me with an 'anti-inflation' fund or portfolio. It might not do 10%, but by definition would do better than the index as it excludes stocks that perform less well in inflationary times...

[NowWatchThisDrive]

mike74 said:

I've rapidly arrived at the conclusion that the notion that "investing in equities is a hedge against inflation" is a actually a huge pile of steaming horse st.

The reality is a bit more nuanced than saying that about the entire asset class.

When liquidity shrinks, the cost of capital increases and you expect asset prices (in the broad sense) to suffer as a result. At its core this is simple supply and demand; the aggregate amount of cash that can be invested, vs the aggregate amount of things that cash can be invested in.

Some stocks perform better in the context of inflation than others. If you own cheap stocks with high distributed cash flow yields, what happens to their market prices, and asset prices more broadly, is less of a concern because while it helps, price appreciation isn't primarily what's driving your returns. Conversely, if you own stocks or funds for which the ostensibly virtuous cycle of rerating/multiple expansion and inflows has been the primary driver of returns, you'll be disproportionately vulnerable to that recalibration of where the liquidity goes when it tightens as has begun to happen now.

[Derek Chevalier]

Simpo Two said:

Indeed. So what we need to invest in now is that part of the index that will perform well in times of high inflation. But rather than make my own picks, as I'm not expert enough, I'd pay a fund manager to do that bit and present me with an 'anti-inflation' fund or portfolio. It might not do 10%, but by definition would do better than the index as it excludes stocks that perform less well in inflationary times...

The potential downsides of this approach are:

1. The scenario (high inflation) you are trying to protect yourself against may never materialise, and you may now have a portfolio that is suboptimal for the many other potential scenarios.
2. The strategy that worked with previous high inflation scenarios might not work this time around (if we do get high inflation).

Much better, IMO, to have a portfolio that does reasonably well across most scenarios rather than a focused one that is going to come unstuck at some point.

[Simpo Two]

Derek Chevalier said:

Simpo Two said:

Indeed. So what we need to invest in now is that part of the index that will perform well in times of high inflation. But rather than make my own picks, as I'm not expert enough, I'd pay a fund manager to do that bit and present me with an 'anti-inflation' fund or portfolio. It might not do 10%, but by definition would do better than the index as it excludes stocks that perform less well in inflationary times...

The potential downsides of this approach are:

1. The scenario (high inflation) you are trying to protect yourself against may never materialise, and you may now have a portfolio that is suboptimal for the many other potential scenarios.
2. The strategy that worked with previous high inflation scenarios might not work this time around (if we do get high inflation).

Much better, IMO, to have a portfolio that does reasonably well across most scenarios rather than a focused one that is going to come unstuck at some point.

We're already in it, and it will only get higher as far as I can see.

So you're happy to see inflation go up five-fold and not do anything?

[DonkeyApple]

The one thing I would add is that an inflation figure of 10% is a generic figure and one must actually look to their own lifestyle so as to calculate what your actual inflation value is.

For some inflation will be negligible and for others worse than 10%.

[Jon39]

mike74 said:

I've rapidly arrived at the conclusion that the notion that "investing in equities is a hedge against inflation" is a actually a huge pile of steaming horse dung.

I heard several people say exactly that in October 1987. "After what has just happened, I am going to stick to cash savings from now on".

Funny how none of them now own an Aston Martin, bought with cash from dividends.
If they have slept better though, then that is good.
Not everyone can cope with the gyrations of the stock market (even though history shows more ups than downs).

[Derek Chevalier]

Simpo Two said:

We're already in it, and it will only get higher as far as I can see.

50 year RPI from 1967-2016 was 5.8% - it's currently 7.8%. I don't see that as particularly high (assuming that headline rate broadly applies to your situation) vs the long-run average.

Simpo Two said:

So you're happy to see inflation go up five-fold and not do anything?

We've previously enjoyed a period of very low "headline" inflation (but booming asset price inflation) - a five-fold rise sounds dramatic, but as you can see, not massively above the long term average.

As Jack Bogle once said, "Don't do something; just stand there" (assuming you have a globally diversified, low cost portfolio at a suitable risk level).

[Simpo Two]

DonkeyApple said:

The one thing I would add is that an inflation figure of 10% is a generic figure and one must actually look to their own lifestyle so as to calculate what your actual inflation value is.

For some inflation will be negligible and for others worse than 10%.

That's a fair point - but we all have to buy petrol/diesel/oil/gas and food. And once everyone knows inflation is going up I think some suppliers use it as an excuse to raise prices even if they don't need to.

You're a bright bloke. With the cost of energy going up by orders of magnitude, a war in Europe underway and likely to get worse, wheat shortages etc etc, would you be reshuffling anything or sitting on your hands like Derek?