Bondholders will take a haircut
I remember the late 1970s very well. I had started my career in 1970 and our family was young. We were saving for retirement. But serious inflation had taken hold of the economy. We had some important decisions to make about investing our retirement savings. I read that common stocks were a better protection against inflation than bonds and I decided to act on that.
That experience and the decision we made at the time are relevant today as we think about the risks of inflation taking hold over the next ten years. I will tell you how it worked out and then we can look into it a bit more deeply.
Between 1975 and 1985 all of our family’s retirement savings were invested in equities. Our returns ranged from -0.7% in 1981 to 31.5% in 1983. The arithmetic average return over the period was roughly 18%. That sounds good but inflation was running hot. We have to keep in mind that these returns were nominal, i.e. not adjusted for inflation.
Peter Lynch remembers that same remarkable time: “There was a 16-month recession between July, 1981 and November, 1982. Actually this was the scariest time in my memory. Sensible professionals wondered if they should take up hunting and fishing, because soon we’d all be living in the woods, gathering acorns. This was a period when we had 14 percent unemployment, 15 percent inflation, and a 20-percent prime rate, but I never got a phone call saying any of that was going to happen, either. After the fact a lot of people stood up to announce they’d been expecting it, but nobody mentioned it to me before the fact. Then at the moment of greatest pessimism, when eight out of ten investors would have sworn we were heading into the 1930s, the stock market rebounded with a vengeance, and suddenly all was right with the world.” (Lynch, One Up on Wall Street, 1989,1990) p75.
I remember those interest rates well. In the late 1970s I invested in the units of a real estate trust that owned three regional shopping centres in Alberta. Interest rates went up and at one point I was paying over 20% interest on the loan.
One other experience from that era is seared in my mind. I was acting for a large group of retired municipal employees whose defined benefit pensions were fixed. The benefits were being mauled by inflation every year. Some had held very senior well-paying jobs, but they were currently living in penury. The pension fund was making good money. The actuarial assets well exceeded the actuarial liabilities. But, the employer and current employees were making deals to use the excess to improve the future pensions of the current employees. The retirees were left out in the cold.
50 years of inflation
Lets’ do a mile high look at the period from 1970 to 2021. During the first 12 years of that period inflation was increasing at a worrying rate. It was called stagflation because the real economy was stagnant while inflation was increasing. Bond holders were getting killed. Since yields were going up, bond prices were decreasing. Anyone on a fixed return was getting hammered. Hence my retired municipal employees suffered.
During the last almost 40 years i.e. since the early 1980s, we have experienced disinflation. That is, inflation has been steadily wrung out of the system. This has in part been because of central bank action. It has also been because of globalization, technology and the steadily improving efficiency of industry, agriculture, resource extraction and other economic inputs. During the last 40 years bondholders have made out like bandits. Not only did they enjoys the high face yields on their bonds, they have also enjoyed capital gains as yields on comparable duration bonds have come down. In my view, the last 40 years has been a one-time windfall for bondholders that will not be repeated.
Since I started saving for retirement in the early 1970s the compounded annual rate of inflation over this 50 year period has been 3.86%. The nominal compounded annual total return on our family savings during this period of was 13.42%. So, basically our returns have stayed ahead of inflation by just over 9% per annum. That is, our real total compounded return on our savings has been 9.56%. During this almost 50 year period, we were 100% in equities for 40 of the years and in bonds and treasury bills for about 10 years.
Stocks compared to bonds
The returns on stocks and bonds over the last 50 years can be seen graphically. We need to look at compound returns. They need to be adjusted for inflation. And they need to be displayed on a semi-log chart. For an explanation of semi-log charts see here.
The chart below comes from Jeremy Siegel’s book, Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long Term Investment Strategies, (1998) p.11. I have read various quibbles about the data. The main message is rock solid. Look carefully at the line for bonds from 1940 to 1980. It goes down steadily. This shows the steady erosion of the inflation adjusted return on bonds during that period. That is the effect that killed my poor retired municipal employees on their fixed pensions.
Particularly in the 1970s debtor governments, corporations and individuals were given a break and bond holders took a haircut to subsidize the borrowers. I say they took a haircut. It was not overt. It was a stealth haircut caused by inflation. In the 2020s bondholders are again taking a haircut as a result of artificially depressed short and long term interest rates thereby again subsidizing debtor governments, corporations and individuals. As I write, 10 year treasury yields are less than the rate of inflation. That difference is the haircut.
We can also see that in other times, for example from 1900 to 1940 bonds did reasonably well. Not as well as stocks. But, ok all the same.
This post is about inflation and how its rise might impact stocks and bonds. So, the period we need to focus on is 1940 to 1980, a period of rising inflation. The contrast is pretty clear. During that period stocks did just fine and bonds did poorly.
My inflation prediction
I have none. I am not an economist, simply an investor. What my experience tells me and what this chart shows, is that bonds do not do well in a rising inflation environment. As well, what I read in the early 1970s, that stocks can provide good protection against inflation, has proven to be true.
So I don’t need to make any prediction. I just need to make sure the risk is covered off.
Thoughts about inflation and a portfolio of common stocks
In times of inflation the best companies are able to not only control their costs but also pass on increased costs to their customers. An example would be supermarket companies. Wholesales food costs may increase as a result of increased fuel or fertilizer costs experienced by farmers or weather related crop size reductions, but the food retailers increase their prices as a result, sometimes with a time lag. Over time the shareholders of the best public companies will find the company earnings, dividends and share prices will be fully protected against inflation. This was the case in the 1970s when serious inflation created huge distortions in the economy.
At certain times companies in the financial sector will benefit from modest inflation. Inflation will lead to increased interest rates that will improve spreads for banks, for example. Companies that have recently completed major capital projects can benefit from a little spurt of inflation if their competitors will have to incur much higher costs to match the new and improved plant and equipment. Each situation must be looked at on its own merits.
As to companies being vulnerable to inflation, each company is exposed in its own way. It depends on what their major input costs are. Trucking companies and airlines are vulnerable to fuel cost inflation. Steel companies can be vulnerable to iron ore and metallurgical coal price inflation. Chemical companies are vulnerable to increased natural gas pricing. Most, but not all companies are vulnerable to wage inflation. This can vary from industry to industry.
A balanced portfolio will have been constructed with all of this in mind.
The evidence and my own experience has taught me that a well-constructed portfolio of common stocks will likely outperform bonds in any inflationary environment and also in any disinflationary environment. There are times when I have sold all my stocks and gone to bonds or treasury bills. But that is another story that relates to true stock market bubbles.
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The stock vs bond debate is discussed in more detail in the Motherlode Part 1: The Field of Play
The Chapters in that Part are:
1. Stocks Beat Every Other Asset Class
2. Is it Worth it?
3. Is it Possible?
4. Risk and Uncertainty
5. Efficient Market Hypothesis
6. Inefficient Market Hypothesis
8. The Economy and the Stock Market – Cycles and Trends
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