Analysts believe the weakness in both stocks and bonds during the first quarter of 2022 was primarily due to investor concerns regarding inflation. These concerns are well founded, as consumers have seen dramatic price increases in two critical and unavoidable household budget items: food and energy.
It has been four decades since investors have had to worry about rising inflation. As a general rule, fixed income investments do very poorly in inflationary times. Buying a ten-year Treasury note (i.e. lending your money to the U.S. Treasury for ten years) will currently generate a 2.35% annual rate of return. This yield is far below the current ~6% level of inflation as measured by the Consumer Price Index (CPI). Simply put, lending your money for ten years to make 2.35% annually when your costs are rising at 2-3 times that rate is not a sound strategy. Of course, what is bad for the lender is good for the borrower—one reason why so many high-quality companies issued debt this past quarter despite having considerable cash on their balance sheet.
Just how bad a deal the recent inflation figures have made lending/fixed income investing can be seen in recent returns for bondholders. We generally use the Bloomberg Aggregate Index as a benchmark for bond returns—data for this index goes back nearly fifty years to 1973. From its peak in early August 2020, this index has seen a drawdown (negative return) of more than 8%. This represents the largest drawdown in the history of the index. The projected annual income yield when the index traded at its peak price of $119.73 was roughly 1.0%. The closing price on March 31st 2022 for the index was $107.10. This capital loss of over 10% represents roughly ten years of income for the unfortunate investor buying in August 2020. The total drawdown of over 8% reflect a 10% capital loss offset slightly by less than 2% in aggregate earned interest.
With fixed income a very poor investment in inflationary times, what kind of investments can work if inflation proves persistent? We favor the ownership of assets, by which we would include stocks, real estate, commodities, and collectibles. The government sells inflation-protected securities but right now these securities are priced to protect investors only in the case of sustained high inflation. Looking at the last period of sustained inflation during the decade of the 1970s, by far the best industry sector to own was energy, as oil and gas prices rose dramatically. The energy sector proved to be the strongest stock market performer in 2022’s first quarter. The Russian invasion of the Ukraine in February raised a concern about an oil and gas supply disruption sending prices up dramatically.
The very high inflation seen in the decade of the 1970’s proved difficult for any investors to overcome. Ultimately equity investors suffered a loss of nearly 30% in purchasing power during the decade despite positive nominal returns. Bond holders fared much worse, losing nearly two-thirds of their purchasing power. We are very mindful of this history.
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