Summary
When one considers all the options and the inherent uncertainty around inflation and its future, real estate, which offers strong real return opportunities with a strong correlation to inflation relative to other assets, seems like a good bet going forward.
Inflation and Why it is a Hot Topic
In response to the coronavirus pandemic, the government and the Federal Reserve have spent trillions of dollars to try and support the economy through the downturn. According to the 2020 Committee for a Responsible Federal Budget, between legislative and Federal Reserve actions, there has already been $4-5 trillion spent, with the possibility of $6 trillion more on the way. The $2+ trillion from the Federal Reserve so far is essentially money created out of thin air. To conduct asset purchases, mainly of US treasuries, asset-backed securities, and corporate debt, the Federal Reserve takes in the assets and credits reserves/money to the participating bank/dealer it traded with. This adds money to the economy that was not there before, and is a direct liquidity injection into the markets, thereby lowering interest rates (one could argue, artificially lowering interest rates).
Historically speaking, if the money supply increases faster than the growth in real economic output, inflation will most likely occur (counterbalancing factors are high unemployment, lower wage inflation, and drastically lower consumer spending). However, the link between the Federal Reserve creating money to buy assets and inflation is not as direct as it may seem. An economic downturn can lead to a decrease in borrowing and lending, which lowers the money supply since the amount of money in the economy is directly tied to the amount of money created through loans and borrowing via the fractional reserve banking system. The actions of the Federal Reserve can be seen as a counteracting force to that decrease. Also, it is often the case that these reserves credited to banks remain held as excess reserves instead of being lent out. Since the funds thus can’t add to the money supply by continuously being lent out and deposited, their impact on the money supply is limited.
Despite the commentary above, it would still be prudent to be prepared when it comes to dealing with inflation. If the excess money created from the Federal Reserve finds its way into the system and stays there, strong inflation could occur if borrowing and lending recover, and there are not large gains in economic output. In addition, the WSJ reported that the Federal Reserve is considering letting inflation run above their 2% annual target for periods of time to make up for other times it was below that target rate.
Asset Classes and Inflation
While stocks are often hailed to offer protection from inflation, this sentiment can be misleading. The reason stocks can be seen as a protection against inflation is because the return on equity through stocks is normally above the inflation rate. However, nothing suggests that stocks will respond to a spike in inflation with a spike in prices. The wisdom of an article written by Warren Buffet in 1977 still applies today (http://www.valueinvesting.de/warren-buffett-on-inflation/). The main message was that the return on equity seems to be a constant number, and the effects of inflation imply no direct benefit to improving that return. As mentioned above, if inflation remains below the return from stocks, there is no issue, but if inflation were to rise by a larger than the normal amount, nothing suggests that stock prices would keep up.
Data analysis supports the idea of a weak relation between inflation rates and stock returns. The correlation coefficient between the yearly percent change in the S&P 500 index price and the annual inflation rate between 1929 and 2019 is only about 0.02, suggesting practically no relation between inflation and stock returns. In comparison, the correlation coefficient between the yearly inflation rate and the yearly percent change in the value of the US Case Shiller Home Price Index between 1929 and 2016 is around 0.54. This implies rises in inflation have been a lot more connected to rises in real estate as opposed to stocks.
While some may not be satisfied with 0.54 correlation, a quick review of other asset options paints a bleak picture. It is no secret that bonds and fixed income perform poorly in inflationary environments, and with yields where they are, there is little wiggle room for inflation to creep in without turning real yields negative. Gold is often thought of the best protection against inflation, but recent work by many economists, including Claude B. Erb of the National Bureau of Economics and Campbell Harvey of Duke University School of Business, have shown that gold does not correlate well to inflation. According to Peter Hug, director of global trading at Kitco, price movements in gold are more often related to the health of economies, supply factors, and central bank actions. Considering this and the recent surge in gold’s price, the idea of buying gold and hoping it will rise further in relation to inflation seems questionable at best. The last asset worth mentioning would be treasury inflation-protected securities or TIPS. These securities offer the only true way to ward off inflation since their principal value is tied to the consumer price index. However, what one gains in safety from inflation, they pay for in return. The current yield to maturity on even the longest maturing TIPS is negative. When one considers all the options and the inherent uncertainty around inflation and its future, real estate, which offers strong real return opportunities with a strong correlation to inflation relative to other assets, seems like a good bet going forward.
Titan Pacific Group is here to help during these challenging times. No matter what side of the market you find yourself on, we can utilize our experience and insider insight to help you achieve the best possible results.
Sources
https://www.multpl.com/case-shiller-home-price-index/table/by-year
https://www.thebalance.com/u-s-inflation-rate-history-by-year-and-forecast-3306093
https://www.covidmoneytracker.org/
https://www.investopedia.com/articles/active-trading/031915/what-moves-gold-prices.asp
https://www.thebalance.com/u-s-inflation-rate-history-by-year-and-forecast-3306093