Welcome back to Efficient Markets!
On today's episode, I am going to spend some time talking about a topic that is on everyone's minds these days - Inflation. I am going to talk about the last time that we saw really high inflation in Canada, how various asset classes responded during those timeframes, what we can take away from that, and the things we can do to protect ourselves against the impact of inflation.
The Latest on Inflation
Inflation in Canada reached an annualized rate of 4.4% in September, the highest reading since 2003 according to Macleans magazine. The Bank of Canada is forecasting that inflation will remain elevated - at a rate of 4.8% through the rest of 2021 (a 3-decade high) and remaining high well into the new year.
So, when did we last see inflation this high?
In the 11 year period between 1972 and 1982, inflation averaged 9.3% per year in Canada. Significantly higher than the inflation we are seeing now.
What happened during that period?
The Bank of Canada expanded the money supply and government spending increased in the early 1970's. By 1974, the Canadian dollar was losing value against the US dollar, after the US let their dollar "float" instead of being tied to the price of gold. This meant that importing goods, particularly from the US, became much more expensive. (OPEC) created export quotas which inflated oil prices significantly. Oil went from $3/barrel at the beginning of the decade to $40/barrel in 1980. Progress in globalization and industrialization caused high levels of unemployment early in the decade, as Canada had difficulty adapting its more industry-heavy economy.
So, how did investors fare during that timeframe?
Remember, the inflation rate for that 11 year period averaged 9.3% over the time period.
How Different Investments Fared in the mid 1970's / Early 1980's Inflationary Period
If the investor had simply stayed in short term treasuries, the risk free asset, they would have returned 11.1% annualized (wow!). I looked back and checked the short term Bank of Canada rate in 1974, and it was 8.50%. So, high interest rates at the start of the period. An investor who stayed in risk free assets would have preserved purchasing power throughout most of the inflationary period from the mid-1970's through the early 1980s.
(Quick Note: The DFA Matrix Book only has data for the FTSE Canada 30-Day Treasury Bill starting in 1974, so the period captured for 30 day treasuries is 1974-1982. Over that same time period, Canadian inflation averaged 9.8%)
If an investor held their money in Canadian stocks (measured by the S&P TSX Composite Index), they would have seen a return of 11.1% annualized (WOW AGAIN). The investor in Canadian stocks had to endure way more volatility to get roughly the same return as short term treasuries. Ie. in 1972 Canadian stocks returned 27.4% (yay!), but in 1974 Canadian stocks returned -25.9%.
If an investor decided to diversify abroad and invest in the US during that period, they would have seen returns of 7.7% for US stocks (measured by the S&P 500). So, diversifying in stocks into the US during this time period would not have helped you boost your returns. US Stocks also saw sharp declines in 1974 (-26.5%).
US Small Cap stocks
If an investor diversified into US Small Cap stocks during that time period, they would have seen returns of 14.3% annualized. So, in the US, significant outperformance of small cap stocks during the inflationary period of the 70's and 80's when compared to large cap stocks.
US Value stocks
If the investor had tilted their small cap US stock holding to value stocks, they would have seen returns of 19% annualized over the time period. Again, significant outperformance compared to holding just the S&P 500. However, small cap value stocks were not immune from volatility during this time period. Between 1973 and 1974, Small Cap Value stocks were down 24.3%. An investor would have needed to hold Small Value through the drawdown and the inflationary period in order to get the return over the whole period.
If the investor had allocated some of their portfolio to Gold over that timeframe, they would have seen returns of 23.82% annualized (according to portfolio visualizer). Gold, just as stocks, was not immune to huge drawdowns during this period. Gold saw 2 separate drawdowns of more than 40% during the time period between 1972 and 1982. even while inflation was persistently high. Again, I am not a fan of Gold as an investment. Returns of gold have been abysmal since the 1980's (3.62% annualized returns since 1982 with massive volatility).
So, what can we take away from the high inflationary period of the 1970's and 1980's in Canada as it relates to our investment approach?
Interest Rates are Much Different Now...but Bonds Still Have a Role
The overnight rate in 1982 was 8.5%. Today, the overnight rate is 0.25%. Investors who keep their money in cash are going to lose purchasing power after you factor in inflation. We cannot expect the same experience as we had in the 1970's - 1980's investors, who could have kept their money in safe bonds and kept up with high inflation. But, short term fixed income assets are still the best way to make sure that you have liquidity and that you preserve your capital for short term purchases.
Risky Assets Are a Great Protector Against Inflation Over the Long Term
For investors to keep up with inflation, they will need to invest in assets that are expected to return more than the rate of inflation over the long run. Historically speaking, no other asset class has done this as effectively and more consistently than equities. Which bring us to our next point....
Stocks are NOT a good HEDGE against Inflation
As we saw as we went through the numbers, while stocks outperformed treasury bills in the high-inflation times of the 1970's and 1980's, they did not beat inflation every year. Canadian stocks, US stocks, Small cap stocks, value stocks - they all experienced drawdowns during periods where inflation was high. Investors can expect the same thing now. They will need to accept volatility to have the opportunity to have the higher expected returns of stocks. This is true in inflationary times, as well as non-inflationary times.
Contrary to Popular Opinion, Commodities and Gold are NOT Good Inflation Hedges
From September 1980 until June 1982, Gold dropped by 52.38%. Meanwhile, Inflation in 1980 was 11.1%, and in 1981 it was 12.1%. Hedges do NOT do this. Again, gold is not a good inflation hedge.
In conclusion, the advice to investors is the same in the face of inflation as it is in the face of bear markets, manias, world events - have an investment plan that matches your financial plan. Specifically, that means:
1) Have short term capital needs in cash or high interest savings accounts - inflation will impact your cash but it is not likely to have a huge impact over short time frames. For near term capital needs, cash is still the best asset class to hold.
2) For long-term investments invest in equities - zooming out, between 1970 and the end of 2020 here are the returns of various equity asset classes in real terms:
Canadian Inflation - 3.8%
Canadian stocks (real return) - 5.0%
US Stocks (real return) - 7.0%
3) To enhance returns, consider tilting towards the types of stocks that have historically provided higher returns
US Small Cap (real return) - 8.6%
US Small Value (real return) - 10.8%
4) Ignore the Headlines
Dimensional Fund Advisors recently released an article titled "Everything Screams Inflation". The article lays out news headlines from various periods from 1970 until today. In each headline, the author was warning readers about "inevitable" inflation. The article then shows the future returns of US Stocks from the writing of that article looking forward 1/3/5/10 years. The point is that high inflation is hard to predict with precision. And, even if you think you can predict inflation more effectively than the market, a move out of stocks for long-term investments has historically not been a great move.
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