If you are a retiree, or even near to retirement, you are probably more vulnerable to inflation than most.
Your cost of living is probably rising faster than your income. You’re lucky if any pension or annuities raise their payouts to match rising prices. Social Security does, but only a year in arrears. If you are in your senior years, the stock market turmoil caused by this year’s inflation crisis poses a significant risk. A lost few years in the markets is more dangerous to someone of 70 than someone of 30.
And then there’s the risk to bonds and bond mutual funds, a staple of the typical retirement portfolio. Bonds suffer the most from rising prices, because the future interest payments are fixed. So the higher inflation goes, the less those payments are worth in today’s money. Meanwhile, as governments fight inflation with higher interest rates, bonds sold with the old interest rate become less and less attractive. They fall in value to compensate.
All in all a dismal outlook, and even worse than that currently faced by the young and those in early middle age.
Last week’s news that October’s official inflation figure had come in below fears has sent stocks and bonds booming. And is causing some to hope that the inflation crisis may soon be over. Maybe inflation has peaked and will start heading back down. Are happy days here again?
Not so fast, warns legendary financial guru Rob Arnott, the chairman of money management firm Research Affiliates.
He’s run the numbers on all the big inflation surges in developed economies going all the way back to 1970. (There were over 50, remarkably.) His conclusion? We will be very lucky indeed if this inflation crisis ends quickly.
Lucky, as in he gives it no more than a 20% chance.
The likelier scenario is that even if it starts to come back down, inflation may persist higher for longer than the markets, money managers, or the Federal Reserve thinks.
That’s because, in effect, inflation has reached the kind of critical mass or momentum this year that makes it much harder to control.
“An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time,” write Arnott and his co-author, analyst Omid Shakernia.
This means us. The official U.S. inflation rate broke above 8% in March and stayed there till September, peaking at 9.1% in June. (And that’s the annual rate, meaning the change in prices from 12 months earlier. The month-over-month change in prices, while much more volatile than the annual figure, has actually shown even faster inflation at points this year—and actually just rose, rather than fell, in October).
“Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more,” warn Arnott and Shakernia.
Once inflation breaks above 8%, they find, “reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.”
There are a couple of important caveats. The first is that the past is no guarantee of the future. Just because these things happened in previous instances of 8% inflation over the past 50 years doesn’t mean they will happen this way this time. (If “this time is different” are the four most dangerous words in finance, as Sir John Templeton once said, “this time is the same” are among the most dangerous five.)
After all, it could work out. The authors write that they are simply handicapping possible outcomes, not making a prediction. “Those who expect inflation to fall rapidly in the coming year may well be correct.” But, they warn, “history suggests that’s a “best quintile” outcome. Few acknowledge the “worst quintile” possibility, in which inflation remains elevated for a decade. Our work suggests that both tails are equally likely, at about 20% odds for each.”
Actually, they add, if U.S. inflation really has just peaked and is on the way down, we should count ourselves pretty lucky. Only 30% of the time in the past 52 years has inflation peaked between 8% and 10% and then gone back down. In the other 70% of the time, once it’s made it over 8% it had risen above 10%.
But what is remarkable about this is that the markets—and the Fed—are currently making this lucky outcome their central forecast. It’s one thing to hope for sunshine when there is an 80% chance of rain. It is another to go on a very long walk without a raincoat or umbrella.
Yet the Federal Reserve is currently (at least publicly) saying it expects inflation to plunge very quickly, averaging 3.5% or less next year and 2.6% or less in 2024.
The bond markets are just as optimistic, and currently bet that inflation will average 2.4% over the next five years.
If they are right, it will all work out. But if they aren’t? Watch out for those bonds and bond funds. Even today, after this year’s surge in yields, the 10 Year Treasury is yielding less than 4% in an environment where prices are rising faster than that. BBB-rated corporate bonds, mean the “riskiest” bonds that still count as investment grade, will pay you 6%. Better, but still not great if inflation doesn’t come down.
Incidentally, a number to watch is the monthly inflation figure. How much did prices rise between last month and the month before? What does that work out to as an annualized figure?
According to the U.S. Labor Department, this has been rising, not falling. It was 0% in July and August. (You may remember the administration boasting about 0% inflation. This is what they meant.) But this figure jumped to 2.5% in September and nearly doubled to 4.9% last month.
Maybe this is a blip, or maybe this is a new trend. Who knows? Nobody, really.
No wonder retired “bond king” Bill Gross likes short-term inflation-protected Treasury bonds. Low inflation and interest rate risk. The iShares 0-5 Year TIPS Bond ETF is his…er…tip.