Occam’s – The Impact of Unexpected Inflation

By October 11, 2018 Uncategorized No Comments

WHAT IS OCCAM’S RAZOR?
Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.


 

In our last Occam’s, we introduced the CARE framework to help those in the fragile first years of retirement think about their overall financial plans. With this Occam’s, we want to drill down on the key components of the CARE framework – starting with your aspirational goals, the “A” of the CARE framework, addressing what we call the four L’s of retirement: longevity, legacy, lifestyle, and liquidity. But before we can do this, we need to spend some time on the impact that inflation may have on any your retirement aspirations. As the saying goes, “everything was fine, until…” and inflation is one of those big “until” things.

Inflation isn’t constant.

Inflation has had an annualized return of 3.12% from 1913 through the end of 2017(1). Like stocks, inflation will fluctuate. During the 1980’s was over 5% per year(2), and in the 2000’s was around 2.5% per year(3). Inflation can also spike as it did in 1979 when it reached 13.9%. The Federal Reserve targets 2.15% as an acceptable rate of inflation, and as of this writing, the bond market expects inflation to be about 2.11% over the next 10 years based onTIPS yields (we’ll talk about this later). Expected inflation, in fact, has moved higher recently, from 1.60% about a year ago to above 2% today. With this moving higher, there have been several articles highlighting inflationary concerns, including the potential effect on the broader economy, and the fact that Core inflation is at the highest level in over 10 years.

What should I do about this?

So how concerned should you be about inflation and importantly, what can you do about it? The short answer is that you should be concerned, but not panicked. Like how long you keep working and when you start taking distributions from your portfolio, inflation is one of the key determinants of a successful retirement plan. A 1% upward shift in inflation can shorten a 30-year retirement target by nine years. As an example, we recently worked with a client where a 1% increase in inflation moved a plan that had a reasonable success rate of 87% to one that had a doubtful success rate of 57%, based on Monte Carlo analysis. While inflation can significantly impact your retirement plan, there are some basic steps you can take to mitigate the severity of the impact.

The first step is to make sure you know what the headline numbers mean and how they may differ from your own “personal inflation rate.” The main inflation gauge, the Consumer Price Index (CPI), attempts to show what an “average” consumer will encounter when they buy a basket of goods. You may not be the average consumer though. You could be an off-the-grid type of person, where you have paid for your home, grow your own food, drive old cars, and are not interested in the latest electronic gadgets – and intend to be self sufficient until you die. In this case, inflation may not be that a big deal to you. So what if televisions are priced at $20,000, if you don’t watch television? Still, even the off-grid person will probably need a tractor to plow the field at some point, and the Kubota that costs $40k now, may cost $150k in the future with inflation. The important point is to know your inflation pain points as you enter retirement.

As boring as this sounds, another key factor to insulate your retirement plan from inflation is to have a broadly diversified portfolio of stocks and bonds. And within the bond portfolio, you should consider allocating a significant percentage to TIPS (Treasury Inflation Protected Securities). Before we get to why equities make sense and why things like gold and silver are not good inflation hedges, let’s first talk about TIPS.

TIPS can be said to be among the safest of all investments. They are backed by the full faith and credit of the US Government and protect against “unexpected” future inflation. They provide this protection by increasing the principal of the bond with changes in the CPI. If inflation skyrockets to 13%, or something we are not expecting, the TIPS bond holder will be credited additional principal that reflects the 13% CPI increase. The nominal, or what we usually think of as a regular, bond will not get this additional principal and will only get paid to what was agreed upon when the bond was first purchased. A current pricing comparison of the two types of bonds, TIPS and Nominal, helps explain what is going on:

Bond Coupon Price Yield to Maturity
10-Year US Treasury Nominal 2.88% 98.55 3.05%
10-Year TIPS .75% 100.16 .90%
Breakeven or Expected Inflation (The Difference between the two yields 2.15%

The above quotes are from 9-27-2018. Because inflation has yet to be credited to the principal of the TIPS bond, the TIPS yield of .90% is lower than the nominal bond’s yield of 3.05%. The difference between the two yields is the market’s best guess of inflation. In this case, the expected inflation is 2.15%. This means if inflation turns out to be higher than 2.15%, then the TIPS bond holder will have been the better investment and if inflation is lower than 2.15%, the nominal bond will have been the better investment. Since we are not witches and can’t predict what inflation is going to be, it makes sense to hold both types of bonds in your portfolio.

Commodities aren’t your friends.

When we discuss inflation protection, we often get questions around the benefit of commodities as an inflation hedge. In our view, commodities don’t do much of anything as an inflation hedge. Here are some updated numbers on commodities, inflation, and the S&P.

Asset Annualized Return Annualized Standard
Deviation
Growth of $1
S&P 500 10.09% 14.0% $13.95
Commodities Bloomberg Commodity
Total Return Index
2.36% 14.46%   $1.90
US CPI 2.31% 1.13%   $1.87
Data is from 2/91 through 6/18

As you can see, commodities matched inflation over this period, but with even more volatility than the stock market. And unfortunately, that volatility doesn’t work in your favor. The stock market may have had commodity like volatility, but at the end of the period a dollar invested in the stock market would have grown more than 7 times more than a dollar invested in commodities (and this doesn’t even take into account the different in the expenses involved in investing in a fund tracking the S&P 500 index and a fund investing in commodities).This gets to the essential difference between the two: commodities are just things whereas stocks represent organic, growing concerns and because of this, there is a higher expected return with stocks.

In summary, while inflation is a big driver of whether you will be able to meet your retirement aspirations, there are very practical, easy steps you can to take to help insulate your retirement from the inflation’s impact. Knowing your inflation pain points will help along with building a broadly diversified portfolio of stocks and bonds. And, don’t forget about including TIPS in your bond portfolio!

  1. Return calculated from Consumer Price Index for All Urban Consumers: All Items [CPIAUCNS]. Data retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCNS
  2. It’s annualized return was 5.06% from 1980 through 1989.
  3. It’s annualized return was 2.52% from 2000 through 2009.
 

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