So consumer prices are tracking 9.1% higher than they were a year ago . . . despite the Fed’s most aggressive efforts. The strategic ramifications for investors go beyond the headlines.
Yes, inflation hurts. It’s not fun to watch your money buy less and less with every passing month. Even if our income remains the same, we find ourselves not being able to afford as much as we did.
Budgets get strained as dollars get stretched. The natural response is to pull back on spending in order to ensure that enough shrinking dollars are available to pay for necessities . . . and that’s exactly what the Fed is hoping we’ll do.
Lower demand in the system means less pressure on suppliers. In theory, prices will stabilize. However, any pullback on spending also cools the economy. Cash simply stops flowing to corporate balance sheets.
And while Main Street might be able to tolerate a little household austerity, Wall Street needs those corporate balance sheets to keep expanding in order to maintain any confidence at all. That’s how many ground-level investors view inflation.
However, there’s a more pernicious aspect to all this. Investors with deeper pockets and longer perspectives have a basic set of priorities that guide all their movements. And inflation creates unique challenges for them that in turn drive the market.
First, inflation has eroded all dollar-denominated pools of wealth by 9% over the past year. If you had $1 billion last summer, you have the equivalent of $910 million now. You’ve lost ground.
Traditionally, you avoid losing ground by parking that money in investments that can earn at least the current inflation rate. It’s simple math. Inflation is a drag on your real returns, so if you aren’t earning enough to balance that drag, you’re falling behind.
Normally inflation is low and stocks do well enough to overcome it. The math isn’t difficult . . . over time, inflation averages about 3% a year and the S&P 500 delivers 10% or 11%, so you’re still making money even if you’re content to hang out in a generic index fund.
But some years, unfortunately, inflation spikes and stocks stall. When that happens, you just can’t protect your wealth from the combination of volatility and deteriorating purchasing power.
In the past 12 months, to pick a particularly painful time period, the S&P 500 has dropped 13%. That $1 billion institutional investment fund is now worth $870 million . . . and then each of those dollars is worth less, so they’re about 21% less rich in real terms than they were last summer.
Ouch. When the market drops like that, bonds generally provide a little shelter, which is why institutional investors love them. As long as the coupon yield is above inflation, you’re still making money even if the underlying bond prices go nowhere.
That’s not the case either this year. If you bought one-year Treasury paper last July, you locked in a minimal 0.08% yield, which doesn’t provide much of a shield at all when prices are soaring.
Holding that paper to maturity means you cashed out the equivalent of $91 for every $100 you put in a year ago. It beats the stock market, but you’re still poorer.
And that’s what you get if you hold to maturity. The price of short-term Treasury paper has dropped 5% over the past year . . . and so that institutional investor has an awkward choice to make. Sell early and take a loss. Or hold on and take a slightly smaller loss.
Obviously the smaller loss is better if losing money is inevitable. But sophisticated investors won’t settle for that.
I know of at least one company that you could have bought a year ago at $21.19 and it’s paid the equivalent of a 12% dividend yield in the meantime . . . not missing a single distribution. The stock, meanwhile, has dropped a relatively mild 3%.
Add it all up and shareholders maintained the same purchasing power they had a year ago. No real profit after inflation, but no erosion. No loss.
Where would you rather be? Obviously, it’s better to break even than it is to lose money. And the thing about bonds is that unless demand increases to the point where you can sell higher than you bought, you’re never going to earn more than the interest rate you locked in at the beginning.
Normally that’s part of the appeal of the bond market. The income you earn is reliable. It’s “fixed.” You can plan around it.
But when inflation is tracking above that rate, you’re locking in a guaranteed loss in real terms. Stocks, on the other hand, are always a little uncertain depending on the day and Wall Street’s moods.
Hold that company I’m thinking about for a few more months or even weeks, and you might be looking at a paper profit even after factoring in inflation. On the other hand, if the stock goes down, you only need to hold your shares and keep collecting that 12% yield.
In that scenario, the stock price is almost incidental. You’re keeping ahead of inflation and moving ahead year after year . . . even if inflation edges even higher.
All that needs to happen is that the company keeps earning enough cash to make its quarterly distributions. So far, so good. Cash flow here didn’t falter in the pandemic. It’s going to take a huge shock to knock that confidence.
You can see this play out on a larger scale with stocks like Johnson & Johnson (JNJ), which has a better credit rating than the U.S. Treasury. Statistically, a default here is vanishingly unlikely.
A year ago, you could have bought JNJ at $170 and figured you could probably book about $4 per share in dividends for a 2.4% yield. That’s a whole lot better than 1-year Treasury paper, right?
And the thing about companies is that they can grow. JNJ has boosted its dividend 5% in the past year so now that 2.4% yield has crept up to 2.5%.
Over the past decade, dividends here have soared 76% . . . if the future looks anything like that history, you could be earning 4.4% on JNJ when 2032 rolls around. That’s not enough to keep up with ambient inflation today, but it’s well above the long-term trend.
And needless to say, the stock is worth a whole lot more. A decade ago, JNJ went for $65. If you locked that in, you’re earning over 6.6% a year now.
That’s better than the erosion we’ve seen in the bond market. And it’s why I urge you to test “conventional wisdom” with your portfolio.