Everlake Guide to Inflation

Executive Summary

It can be easy for investors to feel overwhelmed by the relentless stream of news about markets. Being bombarded with data and headlines presented as affecting your financial wellbeing can evoke strong emotional responses from even the most experienced investors.

We should remember that markets can be volatile and recognise that, in the moment, doing nothing may feel paralysing.

When faced with short-term noise, it is easy to lose sight of the potential long-term benefits of staying invested. While no one has a crystal ball, adopting a long-term perspective can help change how investor’s view market volatility and help them look beyond the headlines.

Inflation has not been a serious or persistent economic problem in developed markets for decades but naturally as investors have seen their portfolios decline this year, many are beginning to question if they need to do anything different.

In this guide to inflation we examine the history, the cause of the recent climb, and how we should react.

Introduction

Annual inflation in Ireland jumped to 7.8% in May of 2022, the highest since September of 1984 and accelerating from a 7% rise in the previous month.

The main contributers to higher inflation were housing and utilities (20.9% vs 17.1% in April) and transportation (16.5% vs 18.9% in April), as surging oil prices lifted costs for home heating and vehicle fuels.

The Consumer Price Index (CPI) also accelerated for restaurant and hotels (5.9% vs 5.1% in April), and food and non-alcoholic beverages (4.4% vs 3.5%). On a monthly basis, consumer prices were up by 0.9%, rising by the same magnitude from the previous month.

Source: Central Statistics Office Ireland

Putting this into longer term historical context, inflation is currently elevated relative to the average inflation rate since the mid-1980s.

Further context can be provided by looking at the European Cenral Bank base rate since the birth of the Euro. We can see that there is currently a substantial mismatch between the current rate of inflation and the current ECB base rate.

We can see that previously when inflation has been around 5% the ECB base rate has been over 4%.

The ECB flagged a 25-basis point interest rate hike in July 2022 and said a bigger increase may be needed in September 2022 as inflationary pressures were increasing and broadening, raising the risk that high price growth will become entrenched.

The ECB now sees inflation at 6.8% this year, more than three times its target, and price growth could hold above 2% through 2024.

"Pundits forecast not because the know, but because they are asked” - John Kenneth Galbraith

Our Observations

• Eurozone inflation was running at 2.2% in July 2021 and is now running at 8.1% at the end of May this year.

• This is a 40 year high resulting in Central Banks around the world flagging that interest rates will have to go up and this has naturally spooked the markets.

• This comes on top of supply-side energy crisis on the foot of the Russian invasion of Ukraine and the pent up demand from the wall of cash saved up during the pandemic have led to the perfect storm for capital markets.

• The worst hit investments are Tech Stocks with even a broad basket, as measured by the Nasdaq, down 30% YTD.

• A slight reprieve for Irish investors since the US$ is up over 8% against the Euro. Investing globally is generally always the right answer.

• Cash has been the worst investment over the last 5 years and that is consistent with history where you will barely keep pace with inflation over time

• Low risk ‘defensive’ Fixed Interest or Bonds have performed a valuable function this year dropping less than the stock market consistent with their role in a portfolio

• However, the last 6 months have been the worst in recorded history for the bond market. We have data going back to 1926 and there isn’t a 6-month period in modern history which is worse for investors. Year to date the 5-year US Treasury note, generally seen as one of the safest investments on the planet is down 7.60%.

• Wherever you look around the world, without exception, investors in bonds are down this year with US Longer Term bonds down over 23% Year to date.

• Despite this, over 5 years bonds have fared better than cash as a defensive asset in a pension portfolio.

• At Everlake, we have been recommending State Savings Certificates for personal accounts and this strategy has proved to have been extremely beneficial for our clients.

• Looked at over just the last 2 years, the Stock market has been a great place for our clients and over 5 years returns have been exceptionally strong.

• The message is: Stay the course, this is unusual but nothing to worry about

Inflation in Ireland in the Recent Past & Causes

We saw spot prices of gas and heating oil increase dramatically recently but we can also see that they fell dramatically in 2020.

What this means is that the percentage increase in energy prices that we see today, year on year, is due to their calculation from a low base. Prior to the invasion of Ukraine, the ECB commented on the temporary nature of these energy ‘base effects’ and was projecting that this effect on price inflation in the Euro area would be gone by early 2022.

Clearly that hasn’t turned out to be the case.

Source: European Central Bank, Economic Bulletin 5, 2021

How Can We Protect or ‘Hedge’ Against Inflation?

We can see that in the recent past, short term cash deposits (as measured by the 6-month Euribor) have done a reasonable job of keeping up with inflation.

This has also tended to be true over the long-term as the data from 1955 in the UK clearly illustrates.

Source: includes composite data from multiple sources including Office for National Statistics in the UK

From this, we can conclude that short-term fixed interest has, historically at least, been a reasonably good hedge against inflation, and we see a similar picture in the USA since the 1920s.

We can also see that slightly longer-term bonds, 5-Year Treasury Notes in this example, have consistently offered a premium return.

A consideration that investors have been grappling with for some time now is the inverse correlation between interest rates and bond prices. Simply put, when interest rates go up, Bond prices absolutely will go down.

In the recent past we learnt to live with the idea that trillions of government bonds were trading at negative yields and even today, some savers are still being charged for their cash deposits.

But while this may strike many as unnatural, it is not unprecedented. In the Great Inflation of the 1970s real interest rates were extremely low or negative across much of the developed world.

Again, if we look to history, we can get a sense of how risky it is to hold Fixed Interest Bonds when interest rates increase.

GraphofSemi-annualreturnsof5-yearUSTreasuryNotes1926to2018

Source: Ibbotson & Associates

We can see from the graph above that whilst there are periods of negative semi-annual returns, historically at least these have been both brief and relatively shallow.

Source: FE

Putting the first six months of 2022 into historical context it would seem to have been the worst in recorded history for the bond market.

The Year-to-date return for the 5-year US Treasury note, generally seen as one of the safest investments on the planet is, at the time of writing, down 7.87%.

Source: FV00 | 5-Year U.S. Treasury Note Continuous Contract Overview | MarketWatch

Wherever you look around the world without exception investors in bonds are down this year with, as would be expected, US Longer Term bonds down over 23% Year to date in local currency terms.

Source: Wall Street Journ

Inflation-Linked Bonds

Breakeven inflation (BEI) rates offer a window into the market’s inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.1

The one-year BEI shows a spike in inflation expectations this year following increasingly high consumer price index (CPI) changes. But the trajectory appears to have changed course over the past couple months. Since peaking at 6.3% in late March, the one-year BEI had fallen to 5.2% as of June 10.

This might be the market’s way of telling us it sees inflation getting under control in the near future.

1-year breakeven inflation rate, January 1, 2021–June 10, 2022

Source Dimensional Fund Advisors

1 Moreaccurately,thedifferenceinyieldsbetweennominalandinflation-protectedbondsrepresents bothexpectedinflationandaninflationriskpremiumbornebyholdersofnominalbonds.

It is important to remember that realized inflation can diverge from expectations as the chart below shows.

While nominal (i.e., not inflation-protected) bond prices reflect expected inflation, investors who opt for Treasury Inflation-Protected Securities (TIPS) or approaches that overlay inflation swaps (“real return” bond strategies) get compensated for actual inflation. Investors who want to reduce uncertainty in the event of higher-than-expected inflation may benefit from these inflation-hedging approaches.

However, it’s important to remember that inflation-linked bonds tend to be very long term and are therefore susceptible to changes in the real interest rate and you can’t write a hedge against that so there is still a lot of uncertainty around how inflation-linked bonds perform in the short-term as the graph below illustrates.

Source: FE

We can see that although realised inflation has increased recently which has benefited inflation-linked bonds, the market has projected an increase in expected future interest rates which has had a greater negative impact in the short-term.

Extending investment terms too far may result in diminishing returns/risk trade off.

Not all investors define risk as volatility as measured by standard deviation . Some invesors (such as Insurance Companies) may seek to hedge long-term liabilities using long-term bonds.

Historically, longer maturity instruments have higher volatility and have not provided consitentaly greater returns.

Surely Bonds are a Return Free Risk?

This is where you need to be careful what you read. It is true that the capital value of a bond is inversely related to interest rates and therefore falling (or rising) interest rates result in rising (or falling) bond prices.

However, the bond index funds we use in our client’s portfolios have stable durations. What this means is that they generally hold bonds with a particular term to maturity. As these bonds mature, they turn into cash and are reinvested.

Since interest rates have gone up, this cash is now reinvested at a new higher interest rate. This constant process of maturing and reinvestment results in a wonderful side effect which is that short-term high credit bonds are a reasonably good hedge against inflation.

Dataasat31stAugust2021

ComparedtotheendofMay2022

Source: Vanguard

We can see that the average Yield has increased from 0.31% in 2021 to 2.87% at the end of May 2022. Investors in the fund or cash being reinvested from maturing bonds are now earning more than 2.5%pa more than in August last year.

The 1970s

Ok, but what about the 1970s? Inflation was out of control and commodities were the thing to own.

So, yes commodities were a relatively good bet for that decade but look how much volatility they come along with

You are trying to hedge something which looks like this from month to month:

With something that behaves like this:

And we can see what a big component oil represents in that index:

Which would explain why it did so well in the 1970s when OPEC doubled and then re-doubled the price of oil.

But if we take a step back and look at this in context, we can see that commodities are of questionable benefit in a portfolio when compared to bonds.

And the same is true of precious metals:

Which generally don’t perform much better than cash over time but have ridiculous levels of volatility relative to inflation:

Property

Now you’re going to tell me that houses aren’t safe right?

Data from the Office of National Statistics in the UK showing average house prices in the UK since 1987 compared to global equities: Source: FE

Stock Market Value

Ok well then, the stock market is overvalued surely?

Graph of the price earnings ratio for the S&P 500 for the last 90 years:

The market isn’t currently cheap like in say in December 1979, but neither is it really expensive like in 2000. Over this whole period the index averaged to return investors about 10%pa. Time in the market is more important than attempting to time the market.

Whilst there is a heightened possibility of a recession, history tells us that the market reaction is forward looking and by the time the recession is upon us, the markets may have already begun to increase again.

Source: S&P 500

Source Dimensional Fund Advisors

Conclusion

It is said that the market ‘climbs a wall of worry’. There is always some news story trying to grab investors’ attention or more accurately make them abandon their well-thought-out investment portfolios and jump on whatever passes as the latest fad.

But, the evidence is clear, over the long term, equities are the investment of choice and as the graph below clearly shows, equity investors should be more concerned with the spectre of deflation as we saw in the 1930s rather than inflation.

Disclaimer

This document has been prepared for information and educational purposes only and should not be relied upon by any individual without seeking specific guidance on the suitability of any course of action for their unique circumstances.

Taxation

References to Taxation have been obtained from sources which we believe to be reliable and are based on our understanding of Irish Tax legislation at the time of writing. The level and bases of taxation are based on current legislation (tax year 2022) and may change in the future. We cannot guarantee its accuracy or completeness.

The rates and bases of taxation may change in the future. The Central Bank of Ireland does not regulate tax advice.

We recommend that you obtain specific tax advice for your own personal situation. We will refer you to a suitably qualified tax consultant on request.

Investments

As with any investment strategy, there is potential for profit as well as the possibility of loss. Past experience is not necessarily a guide to future performance. The value of investments may fall or rise against investors’ interests.

Any person acting on the information contained in this document does so at their own risk. Recommendations in this document may not be suitable for all investors. Individual circumstances should be considered before a decision to invest is taken.

Income levels from investments may fluctuate. Changes in exchange rates may have an adverse effect on the value of, or income from, investments denominated in foreign currencies.

We do not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable.

Warning: the value of your investment may do down as well as up. This service may be affected by change in currency exchange rates. Past performance is not a reliable guide to future performance.

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