SPY: How Smart Investors Deal With Inflation

Inflation fears are back with a vengeance. With $6 trillion in fiscal stimulus and potentially another $5 trillion on the way, predictions of 4%, 6%, or even 10% inflation have started circulating on Wall Street.

This harkens back to the fears many investors had about QE-induced inflation in the early 2010s returning us to the 1970s. That was a period of stagflation and extremely turbulent stocks.

In fact, the S&P 500 suffered two bear markets in the 1970s and one in the early 1980s.

Here are the best available facts we have today, about what inflation risks we actually face, and how best to protect our nest eggs should inflation prove worse than expected.

What It Would Take To Bring Back Double-Digit Inflation

Moody’s is one of the 16 most accurate economist teams in the world, according to MarketWatch.

Moody’s chief economist Mark Zandi has crunched the numbers and estimates that the single biggest threat to getting back to 70s style inflation is 8+% earnings growth for 3+ consecutive years.

The reason is that inflation is basically a self-fulfilling prophecy. If companies and workers expect prices to rise quickly and every year, then wages have to rise fast to keep up.

Those wage hikes are passed on to consumer and business prices, creating a hard break cycle of very high inflation.

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In March 2021, wage growth was 4.2%. For context, 4% to 4.5% wage growth is considered healthy, because it requires 2% to 2.5% productivity gains to keep inflation at the Fed’s 2% long-term target.

In other words, there is so far little cause for concern to return to 70s style double-digit inflation.

Even If Inflation Did Soar, Investors Have Little To Fear

Why does inflation terrify so many right now? Some intuitive though overly simplified logic.

interest rates are tied to inflation expectations
low-interest rates are a main reason that many growth stocks were bid up to very high levels
if inflation expectations rise, so might interest rates causing the popping of many stock market bubbles

As with most things on Wall Street, there is some truth to this reasoning.

(Source: Ben Carlson)

Growth does outperform value the most when inflation and interest rates are low.

That’s because the future value of a growth company’s cash flows is theoretically increased by low discount rates, and discount rates are correlated (though not perfectly) with long-term interest rates.

For some of the highest-flying tech darlings, rising inflation could indeed painfully pop some bubbles, resulting in spectacular losses.

However, popular investing themes, such as “rising rates are bad for stocks” and “high inflation is especially bad for stocks” are overly simplified and wrong.

Consider this.

The #1 inflation-adjusted asset class in history, is REITs, which is actually a kind of stock.

A 2019 Dutch study looked at global assets in both nominal and inflation-adjusted terms, all over the world, from 1960 to 2017. Naturally then, there were some high-inflation periods it covered.

It found that stocks in general and REITs, in particular, were still the best-performing inflation-adjusted asset class in history:

Global REIT inflation-adjusted total returns: 6.4% compound annual growth rate
Global stock real returns: 5.5% CAGR
Non-government bonds: 3.5% CAGR
Government bonds: 3.1% CAGR

That might shock many, who know of REITs as the ultimate “bond alternative”.

However, no stock is actually a bond alternative because the value of bonds is based on interest rates, default risk, and time to duration.

The value of stocks is based on the discounted future cash flow of the company, which of course, is far less predictable and influenced by dozens of factors.

But allow me to kill the “high inflation is terrible for stocks and REITs especially” idea once and for all.

Let’s consider the worst inflationary period in US history.

From 1974 to 1981 inflation averaged 9.6% per year, and it peaked in 1979 at 13.5% as measured by CPI.

Interest rates got as high as 20% at the Fed and 16% for 10-year Treasury yields in 1981. Remember those horror stories from your parents or relatives about 14% mortgage rates? This what they were referring to.

How horribly did stocks and REITs, in particular, fair when inflation and interest rates were their highest levels in recorded history?

From 1974 to 1981 the stock market, despite three bear markets, delivered 10.3% CAGR total returns. Granted after inflation it was just 0.8% CAGR.

However, given the large number of bear markets creates by things like two oil shocks, two recessions, and various other crises, the fact that investor purchasing power was maintained at all, is very impressive.

Since 1926 inflation has averaged 2.9% and dividend growth 4.9%. In other words, dividends tend to grow much faster than inflation, sustaining one’s purchasing power.

Now let’s consider REITs, the so-called “bond alternative”.

Guess how REITs performed during this period of sky-high inflation and interest rates?

In 1979, they delivered 24.3% total returns or 10.9% after inflation.
From 1978 to 1980, they delivered 23.1% total returns per year or 11.6% adjusted for inflation.
From 1974 to 1981, REITs delivered 16.3% annual total returns or 7% after inflation.

REITs actually boomed during the highest inflationary period in US history. REITs also did well globally, from 1960 to 2017, a period that included many high inflationary periods in various countries.

What possibly explains stocks doing not terribly, and REITs ripping higher when interest rates were as high as 16%?

That’s what we’ll explore in part two of this series, where we’ll also see what kinds of companies are best positioned to do well in a high inflationary environment.

SPY shares were trading at $414.80 per share on Thursday morning, up $3.35 (+0.81%). Year-to-date, SPY has gained 11.31%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Adam Galas

Adam has spent years as a writer for The Motley Fool, Simply Safe Dividends, Seeking Alpha, and Dividend Sensei. His goal is to help people learn how to harness the power of dividend growth investing. Learn more about Adam’s background, along with links to his most recent articles. More...