Positioned for Regime Change - Staying Truly Diversified

The plain and simple fact is that while stocks do go up over time, relative performances of different asset classes tend to go in cycles.  These cycles are often impacted by the changing economic cycles.  For instance, as Schwab has been touting for a while (Schwab's Market Perspective), international stocks performance vis-à-vis U.S. stocks tends to alternate after many years of one or the other dominating.

Interestingly, we often see leadership change during key economic inflection points including the Covid-19 recession.  After many years of outperforming, the hot asset class/sector tends to get overbought and expensive while the laggards are underbought and cheap.  The key is that we don’t really know when things will change as we cannot predict markets.  We don’t want to abandon the winners if they’ve still got more room to run nor move fully into the laggards as they could continue to lag.  So, of course, we recommend a two-pronged approach:

• Diversify – the key is to own a variety of asset classes that do not all move together but that we can reasonably expect to have decent returns over time.  We avoid getting killed with one or more bad performers and thus are able to stay on board for the eventual, inevitable recoveries.
• Rebalance – we take advantage of opportunities automatically while maintaining a consistent risk profile.

Get Ready for Inflation?

As noted above, Schwab recently wrote about the cyclical nature of equity performance for international vs. U.S.  I think we might want to consider a potentially more significant shift that could alter relative returns of several asset classes over multiple decades – the possibility of rising inflation.

After four decades of falling inflation and even some brief flirtations with outright deflation, perhaps the time is coming for the trend to reverse.  Let me be clear, I am not predicting that we are suddenly going to move into a period of rising inflation.  I don’t know when the shift may occur … perhaps in 2021 or maybe a few more years.  Yet, I do strongly believe that eventually the regime will shift from falling to rising inflation.  And, interestingly, we might see some indications that the shift will be sooner rather than later.  In particular, interest rates have collapsed from over 20% as inflation peaked some 40 years ago to 0% currently.  Back then, the Fed’s main goal was to break the inflationary spiral with then-chairman Paul Volcker engineering massive hikes in interest rates.  He succeeded and inflation has pretty much fallen ever since.  Currently the Fed, led by chairman Jerome Powell, has taken the exact opposite course by lowering rates to zero, committing to new rounds of quantitative easing, and promising to provide virtually unlimited liquidity to the economy.  Might this period mark the major turning point to a regime of rising inflation?  Time will tell.

Finally, I’m afraid that we all have gotten so used to the paradigm of continually falling inflation and interest rates that we are not prepared for the impact rising prices might have in determining investment winners and losers.

Beneficiaries of Rising Inflation

Before I begin commenting on some possible winners, I want to mention what does well, and has excelled, in a falling inflation world – primarily those asset classes that can consistently generate positive streams of income on a year-after-year basis regardless of how the economy performs.  Money becomes more valuable over time in a falling price world as it can buy more.  These excelling investments include high-quality bonds, such as U.S. treasuries, as well as large, uber-profitable growth stocks, such as the FANMAGs or whatever the acronym of the day is.  These have been the big winners over the last decade.

Now let’s look at some areas that might benefit from rising inflation, which makes money less valuable over time:

Some Potential Winners

1. Developed Economy International Stocks.  Rising U.S. inflation often hurts the dollar.  This decline in the dollar results in an automatic increase in the value of non-dollar-denominated securities such as international equities.  Thus, a declining dollar provides a built-in tailwind to international stocks.
2. Emerging Markets Stocks – These markets, of course, have some of the same benefits as their developed markets’ brethren with the falling dollar, but they also tend to be even more leveraged to the dollar as many of these countries also borrow heavily in U.S. dollars.  Thus, if the dollar is declining in value their dollar debt becomes cheaper and cheaper to service.
3. Fundamental Stock Index Funds.  There are various names for these approaches that tend to weight the size of companies in their indexes based on the economic size of the companies and not simply their market capitalizations.  Diving deeper into this would probably take a whole separate article.  The gist is that these funds tend to have more of a value tilt which can make them more leveraged to economic growth.  Economic leverage means that these companies might really jump when the economy resumes growth as they will benefit greatly with increased sales, even if some of it is simply from higher prices.
4. Smaller-Company stocks.  One potential catalyst for rising inflation is an over-heating economy.  Smaller companies with less wherewithal to tap debt markets tend to really accelerate when the economy is really humming along.  It’s not that inflation will necessarily help, but if it is the result of a perhaps too-strong economy, that would be beneficial.
5. Treasury Inflation Protection Securities (TIPS).  These securities whose principal and interest adjust automatically with inflation are, by definition, good to own in a sharply rising price environment.
6. High Yield Bonds.  This may not seem so intuitive.  However, it helps to realize that companies whose credit quality is not so good tend to need to borrow quite a bit, and at much higher rates than better quality companies.  Yet, what is intuitive, is that borrowers like rising prices as they pay their liabilities back in cheaper dollars.  The real (after inflation) debt burden declines.  (As an aside, inflation may be the course governments around the world take to gradually shrink their own real interest costs.)
7. Commodities and Natural Resource-related companies.  During these last 15 years or so, pundits have been surprised that all the extra money pushed out by the world’s central banks has not generated the expected inflation.  Others argue that there has been inflation, but it has been focused in financial assets and not the real economy.  At some point this will change, and we will see more inflation in goods which often is first reflected in rising commodity prices.  This would likely benefit those who own commodities outright and/or the natural resource companies that work in the processing of various commodities.

To summarize, we don’t recommend that you put all your eggs in these baskets.  However, we do strongly suggest that these components are included in your diversified plans along with some of those that have done well over the last decade.  One attractive feature is that many of these potential inflation beneficiaries have been so out of favor that the prices are still reasonable, offering the opportunity to gain exposure with less risk.