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How to Avoid Paying the Cruelest Tax: Inflation

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With their portfolios gyrating and an election looming, investors are spending more time than usual pondering what their taxes will look like in the future. But they haven’t given much thought lately to “the cruelest tax”—inflation. Maybe they should.

Rising prices can do funny things to a portfolio, most of them bad. Stock prices might rise without really being worth any more, or stay steady and lose buying power. Bonds become “certificates of confiscation.” Broadly speaking, inflation shrinks private savings and bails out people and governments that have borrowed heavily. But not everything withers: Some investments could do quite well.

Right now neither Wall Street nor Main Street expects rapid inflation, and that is a good thing. It is good because they may well be right, but also because investors can protect themselves at a reasonable price: Investments that offer protection look reasonable while more vulnerable ones have racked up nice gains recently. You don’t buy insurance or sell your beachfront home when the hurricane’s already coming.

One reason many pros aren’t alarmed is that some of Wall Street’s best and brightest got egg on their faces predicting runaway inflation after the financial crisis. But some smart money remains wary. A surge in gold buying this summer was one sign of concern. Investing legend Stanley Druckenmillersaid last month that the Federal Reserve’s statement that it would let prices run above their target could mean that they lose control and that inflation could reach 10%. Even a far milder rate of 3% to 5% would make some investments big losers and others relative winners.

Professional investors express their views on inflation through the bond market. Based on something called the 10-year break-even rate, they think it will average just 1.6% over the next decade. That rate was about a percentage point higher back in the spring of 2011 when the Federal Reserve was in the midst of its second big bond-buying program dubbed QE2. Trillions of dollars later we are in QE4, with record budget deficits, microscopic interest rates and trade frictions to boot—all textbook causes of higher prices. Yet Mom and Pop are also relaxed. The University of Michigan’s monthly survey of consumers shows that Americans expect prices to rise by 2.7% annually over the next five years—nearly identical to their average prediction since the recession ended in 2009.

If the textbooks are right this time then the worst victim of a bout of inflation would be bonds. The 10-year Treasury note, yielding just 0.7%, is already an invitation to lose money. Treasurys could fare even worse this time than in past inflationary episodes. How much investors lose, and how fast their money disappears, depends in part on the Fed.

The main reason yields are so low is that the Fed has promised that it won’t raise its target range for overnight rates, which now sits near zero, until the Commerce Department’s gauge of consumer inflation has been moderately above 2% for some time. For the more widely followed Consumer Price Index from the Labor Department, which runs warmer than the Fed’s preferred price measure, that could translate into central bank inaction until inflation was near 3% for a while. A spike in interest rates could cause sudden, steep losses for investors who own bonds through mutual funds. Even “TIPS,” Treasurys indexed to inflation, would lose value.

But not all government bonds would do so badly. Consider China. The Treasury of the world’s second-largest economy has been relatively restrained in terms of stimulus. Nominal ten-year Chinese yields, currently at 3.15% according to FactSet, are around 2.45 percentage points higher than U.S. Treasurys, and the gap in real terms is even higher. If U.S. inflation accelerates, and especially if the Fed keeps rates low anyway, then that return could get an extra boost from the impact of a falling dollar relative to the yuan. No wonder foreign investors bought nearly 300 billion yuan ($44 billion) of Chinese government debt in the first eight months of 2020, triple the amount during the same period last year.

For those who prefer investing closer to home, American stocks don’t do all that badly when inflation rises. That might come as a surprise to people who remember the 1970s. In 1979 Business Week ran a famous cover story: “The Death of Equities: How Inflation Is Destroying the Stock Market.”

From 1973 to 1979 the core consumer-price index, which excludes food and energy, rose at an average pace of 7.3%, while the S&P 500 fell 8.5% over the same period. But periods of milder inflation have been kinder to stocks. From 1990 to 1995 for instance, the core consumer-price index rose an average of 3.8% a year and the S&P 500 rallied 74%.

In theory stocks offer a natural hedge against inflation, at least compared with bonds. Businesses that can raise their own prices should be able to grow their earnings more quickly, helping shareholders keep pace. Since 1880 equities have risen by more than inflation 88% of the time on a rolling, 10-year basis, according to a study by

Goldman Sachs.

Distribution of annualized S&P 500 inflation-adjusted total returns based on average inflation rates over 10-year periods

Annualized returns were

never below 4% when

inflation was between

0% and 1.5%…

Share of returns

0%

10%

20%

30%

40%

inflation

Share of

returns

-2%

0

1.5

2

2.5

3

4

6

2%

11

9

5

4

1

0

0

0

16%

3

3

23

9

8

11

10

0

0

14

7

2

15

5

1

4

11

4

0

12

26

10

5

13

1

6

37

19

2

10

19

19

12

21

12

10

9

11

11

8

returns

22

15

17

12

22

22

9

3

11

6

10

17

20

28

27

22

12

9

6

4

5

12

0

4

10

13

11

16

4

2

2

9

0

2

6

5

1

19

9

0

3

2

0

0

3

1

1

12

25

-2

0

0

0

0

5

8

0

6

32

Average

returns

7.8

10.6

8.7

6.4

6.5

9.3

4.8

8.5%

1.2

…and average returns were

greatest within that range.

Annualized returns were

never below 4% when

inflation was between

0% and 1.5%…

Share of returns

0%

10%

20%

30%

40%

inflation

Share of

returns

-2%

0

1.5

2

2.5

3

4.0

6

2%

11

9

5

4

1

0

0

0

16%

3

3

23

9

8

11

10

0

0

14

7

2

15

5

1

4

11

4

0

12

26

10

5

13

1

6

37

19

2

10

19

19

12

21

12

10

9

11

11

8

returns

22

15

17

12

22

22

9

3

11

6

10

17

20

28

27

22

12

9

6

4

5

12

0

4

10

13

11

16

4

2

2

9

0

2

6

5

1

19

9

0

3

2

0

0

3

1

1

12

25

-2

0

0

0

0

5

8

0

6

32

Average

returns

7.8

10.6

8.7

6.4

6.5

9.3

4.8

8.5%

1.2

…and average returns were

greatest within that range.

Annualized returns were

never below 4% when

inflation was between

0% and 1.5%…

Share of returns

0%

10%

20%

30%

40%

inflation

Share of

returns

-2%

0

1.5

2

2.5

3

4

6

2%

11

9

5

4

1

0

0

0

16%

3

3

23

9

8

11

10

0

0

14

7

2

15

5

1

4

11

4

0

12

26

10

5

13

1

6

37

19

2

10

19

19

12

21

12

10

9

11

11

8

returns

22

15

17

12

22

22

9

3

11

6

10

17

20

28

27

22

12

9

6

4

5

12

0

4

10

13

11

16

4

2

2

9

0

2

6

5

1

19

9

0

3

2

0

0

3

1

1

12

25

-2

0

0

0

0

5

8

0

6

32

Average

returns

7.8

10.6

8.7

6.4

6.5

9.3

4.8

8.5%

1.2

…and average returns were

greatest within that range.

Share of returns

0%

10%

20%

30%

40%

Annualized returns were

never below 4% when

inflation was between

0% and 1.5%…

Share of

returns

inflation

-2%

0

1.5

2

2.5

3

4

11

9

5

4

1

0

16%

3

23

9

8

11

10

14

2

15

5

1

4

11

12

10

5

13

1

6

37

10

returns

19

12

21

12

10

9

8

15

17

12

22

22

9

6

17

20

28

27

22

12

4

12

0

4

10

13

11

2

9

0

2

6

5

1

0

2

0

0

3

1

1

-2

0

0

0

5

8

0

Average

returns

7.8

10.6

8.7

6.4

6.5

9.3

…and average returns were

greatest within that range.

Note: Distribution is trailing 10-year returns based on trailing 10-year average inflation. Data since 1880. Figures may not sum to 100% due to rounding.

Source: Goldman Sachs

But Goldman found the highest real—or inflation-adjusted—returns for equities came when inflation was low. In 10-year periods where the consumer-price index rose by between 0% and 1.5% on average, the S&P 500 posted a real annual return of 10.6%. That return fell to 8.7% when inflation is between 1.5% and 2%, and to 6.5% when inflation is between 2% and 2.5%. When inflation is above 6%, the average annual real return was just 1.2%.

Inflation can boost companies’ revenue, but it boosts costs too, and not all businesses have the pricing power to keep up. One sector that does, and that could provide a good hedge this time, is natural resources.

Skeptics might say that this impression is skewed by the experience of the 1970s, which was marked by three events that juiced returns for metals and energy: the Nixon shock of 1971 when the U.S. dollar’s link to gold was severed, the 1973 Arab Oil Embargo when crude prices quadrupled and the 1979 Iranian Revolution when they surged again.

But the stretch between 1973 and 1982 actually was one of the least impressive periods for metals and energy stocks in real terms, according to data from fund manager GMO. The combined sectors’ real return was just 0.6%, though that still beat the S&P 500’s overall performance by more than 5 percentage points.

Looking at all eight stretches since 1930 that saw high inflation as defined by GMO, energy stocks had a real return of 6.2% while the overall market fell by 1.6%. Despite being remembered for gas lines, the “stagflation” of the 1970s and early 1980s hurt demand and resource stock valuations.

Owning gold was a famously good bet during much of the 1970s: The yellow metal hit its all-time high adjusted for inflation of $850 an ounce in 1980. But as GMO’s Matt Kadnar points out, the historical return of gold adjusted for inflation over many centuries has been about 0%. It pays no dividend and is really only attractive to those who fear that paper assets like stocks will somehow fail to be honored. And, while gold prices are already close to all-time highs, energy and materials stocks have lagged behind the market sharply. The two sectors combined now make up less than 5% of the benchmark S&P 500—about half their share from five years ago and a quarter of what they made up 30 years ago.

Retailers might be another good place to ride out an inflationary wave, though it matters what the company sells and how flush consumers feel when prices start rising. Sellers of consumable goods such as grocery stores

Kroger

and Albertsons, big box retailers like

Walmart

and Target and even dollar stores are likely to fare well no matter what the unemployment levels are because they sell essentials. The same goes for auto parts and home improvement retailers: Broken cars and homes need to be fixed, even if doing so becomes more expensive.

On average, even a milder inflation rate of 2% helps most companies selling consumables, notes Scott Mushkin, equity analyst at R5 Capital. Volume growth is minimal for consumables, which means anything that moves revenue incrementally higher, such as inflation, will benefit those companies.

Food retailers with successful private label brands, which yield higher margins, might see an advantage over those that don’t. Supermarket-branded soup, for example, will look more appealing than Campbell’s at a time when everything becomes more expensive. Sellers of discretionary items might suffer though if wages don’t keep up with inflation. Sales of appliances and full-priced apparel could shift to off-price retailers.

In an inflationary environment, retailers have incentive to stock up on inventory before prices rise even higher, according to Prof. Gerard Cachon at the University of Pennsylvania’s Wharton School. That means companies with strong balance sheets and vendor relationships should have an advantage. That will be even more important if the higher inflation comes with higher interest rates, pushing up borrowing costs. Cash-rich retailers like Walmart and

Costco

would be better positioned than Target and

BJ’s Wholesale,

while

Dollar General

would have an edge over

Dollar Tree.

Technology and health-care stocks, both recent market darlings, look iffy if inflation hits. While parts of the tech sector such as software-as-a-service might be nimbler at passing on rising costs, tech valuations are high and have proven to be very sensitive to rising long-term interest rates. Meanwhile, health-care inflation has already been high and any attempt by the government to cool price gains could target drugs and medical care.

Utilities and real estate could face a double whammy. Many investors own them for their yield. If bond yields rise then they would look worse by comparison. And both regulator-controlled utility rates as well as long-term commercial leases could be slow to adjust to an uptick in prices even as borrowing costs rise.

Even worse than those industries would be financials, though how bad depends on the Fed. Banks are both borrowers and lenders, but they also must fund themselves with a base of equity and a relatively small share of their assets are hard assets like real estate. Historically, therefore, banks experience more of the downside of inflation as creditors. Past periods of high inflation have been marked by declines in book value multiples, according to a compilation of historical data by Autonomous Research. High U.S. inflation in the 1940s and 1970s saw nadirs for bank price-to-book ratios. By contrast, the most recent peak ratio was hit during the low-and-stable years of the late 1990s.

SHARE YOUR THOUGHTS

What are your inflation expectations for the next few years? How are you adjusting your portfolio to reflect that view? Join the conversation below.

However, in a return to a period of somewhat higher but overall steady inflation—not unlike the 1990s—inflation itself might not be a major determinant of banks’ performance. Much more important would be the degree to which the Federal Reserve was willing to let long-term rates rise. The steepness of the curve is a big factor in banks’ profitability.

It is tempting to trust that inflation went the way of disco and bell bottoms, but hope isn’t a strategy. Investors concerned about protecting the buying power of their savings don’t need to take refuge in precious metals or cryptocurrency—there are some plain vanilla options that could hold up well.

Write to Spencer Jakab at spencer.jakab@wsj.com, Aaron Back at aaron.back@wsj.com, Justin Lahart at justin.lahart@wsj.com, Nathaniel Taplin at nathaniel.taplin@wsj.com, Jinjoo Lee at jinjoo.lee@wsj.com and Telis Demos at telis.demos@wsj.com

Corrections & Amplifications

Figures in the graphic about distribution of returns based on inflation rate are since 1880. An earlier version of this article incorrectly said they were since 1980. (Corrected on Oct. 2)

Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8

Appeared in the October 3, 2020, print edition as ‘How to Avoid the ‘Cruelest Tax’.’

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