The ominous letter
This past weekend my wife and I received an ominous letter in the mail from Penn State University, where my son will enter this fall as a freshman in the college of engineering. It was the sort of letter parents hate to receive: a dreadful notice informing us that the university’s tuition, already at historic highs, will increase another 3.5% for all incoming freshman. Having worked with hundreds of clients over the years to prepare them for this day, I actually breathed a huge sigh of relief; the careful financial planning we had done over the past 18 years, the disciplined investing through good markets and bad, and the diligent funding of 529 plans—even when we couldn’t afford to—had all prepared us for this moment. We had beaten inflation, over time, even if there was little we could do to combat the 3.5% increase that’s coming this fall.
Is inflation coming?
I’m often asked, given the current environment, if I think inflation is coming. Of course it is. First, it never really goes away; it’s a matter of degree, not whether we have it any one time or another. Inflation, for example, has averaged about 1.7% annually over the past decade.1 And as I type this, rising bond yields and real-time inflation data suggest higher inflation may be coming in the near term; most indicators suggest expected inflation of about 3% over the next year.2 That’s certainly not late 1970’s-style inflation but it’s above the Fed’s 2% long-term inflation target.
An increase in inflation makes sense given the current environment. The U.S. federal government has thus far spent approximately $5.7 trillion to combat the economic impact of COVID-19.3 That’s unprecedented fiscal stimulus. Further, with nearly 40% of Americans having now received at least one dose of a vaccine4, the economy is in the process of re-opening and with it a flood of pent-up consumer demand has already begun to hit the market. First quarter real GDP growth came in at a robust 6.4%, up from 4.3% in Q4 2020.5
While some short-term inflation appears likely, sustained, longer-term inflation doesn’t. For one, much of the demand we’re seeing is better described as reflation—it’s simply the economy returning to normal after steep declines earlier in 2020. For example, oil (WTI crude) hit an average monthly low of $16.81 a barrel for April 2020 and has since returned to about $62 per barrel—about where it stood just before the pandemic.6 Yet this +200% increase in WTI crude since its April 2020 low will continue to influence Headline CPI measures for months to come, even if it’s little more than a return to its pre-pandemic price level. Further, much of the initial rise in consumer spending—fueled no doubt in part by one-time stimulus checks—is likely transitory and won’t persist long-term.
The first step in combating inflation is understanding the long-term nature of the threat, its potential impact on your lifestyle and goals, and then subsequently planning for it. For example, it’s important to recognize that not all inflation is created equal. Headline inflation is just a broad average of many baskets of goods and services. Subsequently, different inflation rates impact households to varying degrees depending on the particular basket of goods and services they consume. Rising tuition expenses are likely to have a greater impact on households like mine with college-bound children than, for example, a couple with young children or a retiree with grown children.
However, regardless of one’s lifestyle, the best time to combat near-term inflation isn’t today; it was years ago. This is because inflation is something to combat over time, not every time. Inflation slowly erodes the purchasing power of our wealth over time; it’s a long-term threat that requires a long-term solution. It’s not something to tactically attempt to outperform over the next month or year. For example, upon learning of Penn State’s 3.5% increase in fall tuition, is there anything I could realistically do now to offset that? Of course not. It’s coming, it’s known, and it’s too late. The time to plan for today’s tuition inflation was years ago; not three months before the bill is due. And besides, my wife and I already beat this fall’s coming tuition increase by systematically investing in a globally diversified equity portfolio over the past 18 years. For example, over the past 18 years the MSCI All-Country World Index significantly outperformed inflation by a staggering +7.72% annually (+9.76% versus +2.04% annually).7 My point? Investors should focus on beating inflation over time, not when it’s knocking at the door.
The second step to beating inflation is to avoid getting sucked into fad, expensive, or esoteric investment strategies. The best approach is a disciplined investment strategy that systematically invests in a globally diversified portfolio. I know, that’s boring. As humans, we desperately want to believe there’s an exciting, exclusive, and effortless way to get rich and beat inflation; or to at least do so better than our neighbor. But as I sit here, faced with four years of tuition bills, I prefer boring. It works. It provides peace of mind, a rarity in today’s world. Imagine explaining to your child that you can’t afford to pay for their college education but that, on the bright side, you had a really exotically exciting investment portfolio at one time. You might think I’m joking but I’ve actually had this conversation with clients more than once. To paraphrase a quote by Nobel Prize-winning economists Paul Samuelson, investing—when done well—should be about as exciting as watching paint dry.
What about gold and commodities?
We’re often told to consider the supposed inflation beating properties of gold and commodities. I’m not convinced for at least two reasons. First, over long periods of time, these asset classes have delivered horrible returns to investors, typically with staggering opportunity costs. Consider the past 10-years, a period that saw massive monetary stimulus and unprecedented government deficits. If ever there was a textbook case for when gold and commodities should’ve outperformed inflation, it was then. Yet over that time the Bloomberg Commodity Index delivered a total return of -47.72% (yes, there’s a negative sign in front of that) versus +18.53% for the Consumer Price Index; gold returned +17.52%, almost perfectly hedging inflation. As inflationary pressures ramped up in Q1 2021, gold royally fumbled, returning -10.41%. Commodities, alternatively, returned +6.92% for the year, pretty much in-line with equities buy also largely fueled by the reflation I discussed previously in things like WTI crude.8
The second reason I’m not convinced gold and commodities are realistic solutions to combat inflation is that, in light of their poor long-term performance, the implication is that investors should rent these asset classes temporarily in an attempt to outperform inflation over a certain (short-term) horizon. But this approach naturally requires a degree of clairvoyance that has yet to evolve in our species. Put another way, there’s no evidence any asset manager can successfully time markets or asset classes. And even if they could, consider the havoc such a strategy would wreck on your portfolio—things like higher management fees, capital gains taxes, a high probability of poor returns, and, quite likely, large opportunity costs. There’s just no way this approach makes sense.
Everything in moderation
What about just a small allocation to gold or commodities? This is every salesman’s Hail Mary pass, an SOS that’s often launched in desperation to save the deal. The plea seems logical enough; after all, why not just a small allocation to whatever it is they’re selling? I reject this line of reasoning for at least two reasons. First, the opportunity costs of giving something an allocation in a portfolio are very real, no matter how small; every decision to invest in something is a decision to forego investing in something else. Asset allocation decisions, no matter how small the mandate, should never be taken lightly. And each decision to invest any asset or asset class must stand on its own merits.
Second, and perhaps more damning, is that we already have exposure to things like gold and commodities in our existing equity portfolios (albeit indirectly, which I would argue is a good thing). For example, energy already makes up 2.8% of the S&P 500 Index.9 Energy stocks, I would argue, are a decent proxy for investing directly in commodities like oil and gas. For example, for the quarter ending 3/31/2021, WTI Crude returned +32.4%; the Energy sector returned +30.9%, with Exxon returning +37.8%.10
What about other commodities? It’s the same story, whether through allocations to emerging market stocks (heavy exporters of commodities) or to U.S. mining and metals companies in the materials sector (which makes up 2.7% of the S&P 500).11 We subsequently have exposure to commodities prices (but through companies that mine, sell, or otherwise transform those commodities into value-added products). For example, the Materials Select Sector SPDR (XLB) returned +9.31% in Q1 versus +6.92% for the Bloomberg Commodity Index.12 My point isn’t that we would ever invest directly in a sector specific vehicle like XLB but that (1) we already have exposure to mining/commodities companies and (2) our existing exposure provides better long-term expected returns than owning the underlying commodities outright.
One ring to rule them all—what’s the best approach to beating inflation?
Consider the below chart.13 You’ll see that it presents asset class returns across four inflationary regimes: (1) high and rising inflation; (2) high and falling inflation; (3) low and rising inflation (this is where we are now); and (4) low and falling inflation.
There are three important takeaways from this chart:
- The first is that getting the inflation regime right matters if you’re considering investing in gold because its returns were quite poor in three of the four inflationary environments; the same can be said for commodities, which had poor returns in two of the four scenarios. REITs, now part of the S&P 500 Index (2.5% weight)14, had returns pretty much in line with those of other equities.
- Second, the sample sizes in each of the individual grids are so small that they’re statistically meaningless. For example, in the bottom left quadrant, you’ll see that commodities and gold had good returns (on par with equities). But this data is from a sample size of only four time periods, a sample size that’s woefully insufficient to draw any actionable conclusions.
- The final takeaway, one that’s actually actionable, is that equity returns, regardless of style or geography, were strong across all four inflationary regimes (a sample size of 33 periods, the sum of all time periods presented in the quadrant). This makes sense. After all, inflation is defined as a general rise in the prices of consumer goods and services. And who provides those goods and services? Businesses do, the same ones you can own through stock ownership.
The takeaway? The case for equities as the best asset class to beat long-term inflation is exceptionally strong—a case that I would argue extends to everything from high yield debt (which is very equity-like), real estate, common stocks and private assets such as private equity, credit, and infrastructure.
The final takeaway – plan early, plan often, stick to the plan, and keep it simple
Inflation is a persistent and powerful threat to the purchasing power of our wealth; I would even go so far as to argue inflation is the most critically important benchmark to consider when assessing the overall performance of our portfolio. It’s not whether or not inflation is coming—it’s always here—the real questions are whether, when, and how it impacts our lifestyles and goals. But fixating on inflation in the near-term is an exercise in futility; it’s largely too late to do anything to combat current or near-term inflation. Investors should instead focus on combating inflation over time by planning early and often, sticking to plan, and investing in a disciplined, diversified portfolio—one designed to build wealth and outperform inflation over time.
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1 Source: YCharts, Inc.
3 “All of the COVID-19 stimulus bills, visualized”, USA Today, March 17, 2021.
4 “U.S. vaccination pace holds above 3 million shots per day for two weeks straight”, CNBC, April 21, 2021.
5 “Consumer-fueled economy pushes GDP to 6.4% first-quarter gain”, CBNC April 29, 2021.
6 Ycharts, Inc. WTI Crude for May delivery (2020) hit a low of -$37.63 on April 20, 2020; $16.81 was average price for the month of April.
7 Ibid. Returns data presented is for 3/31/2003 – 3/31/2021.
8 Ycharts, Inc.
9 JP Morgan Guide to the Markets. March 31, 2021. Slide 14.
10 YCharts, Inc.
11 JP Morgan Guide to the Markets. March 31, 2021. Slide 14.
12 YCharts, Inc.
13 JP Morgan Guide to the Markets. December 31, 2020. Slide 34.
14 JP Morgan Guide to the Markets, March 31, 2021. Slide 14.
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