It depends on which perspective we are thinking about inflation. Yes, inflation is very worrisome. We are getting a “pay cut” even though the dollars flowing into our checking accounts from salaries and retirement sources have not decreased. It makes us think more carefully about how much we drive and what foods to buy. Inflation can be difficult to contain once it starts and the “cure” can be painful.
The last time we experienced high inflation was from 1973-1981. I may or may not have been old enough to remember sitting in the back seat of my Mom’s giant boat of a car waiting to get gas in long gas lines. It was a scary time. My parents, who did not grow up with even a whisper of wealth, became even better at managing their money. My Mom canned foods, always cooked at home (which most people did anyway – this was long before it was routine to get take-out or go out to dinner), and sewed my Dad’s business suits. Yep, she sat down at her sewing machine and sewed business suits out of polyester blend materials. It was SO 70s!
In 1979 Paul Volcker, then the Chairman of the Federal Reserve, had to take inflation head on, which he did by increasing the Federal Funds rate drastically. As you can see in the spreadsheet, inflation exceeded 5% per year every year from 1973-1981. His goal was to make it more expensive to borrow money so people would be less likely to borrow and spend, thus reducing the amount of money chasing goods. This eventually eased inflation, although we first had to endure a recession triggered by the tighter monetary policy. The recession was severe as it was characterized by still high interest rates, rising unemployment rates and business liquidity problems.
The Federal Reserve is going to have to become more aggressive toward interest rates to help contain inflation. Hopefully, the cure will not be as painful as it was in the early 1980s, but it will likely trigger a recession.
If we are thinking about inflation with regards to the equity markets, the scenarios are not nearly as gloomy. I put together this spreadsheet so you could see what, if any, relationship there is between inflation and equity market returns. For sure, there are some years with high inflation where there were corresponding negative markets. However, there are also years where inflation is high where the markets experience dramatically positive returns.
Year-by-year numbers are interesting, but when you look at annualized numbers – what would have been the average return per year over a certain time period – we get an even better story. Let’s take 1973-1981. You can see lots of red in the CPI column, years where inflation exceeded 5%. The annual average inflation rate over that period of time was 9.2%. That is a HUGE number to experience every year for 9 years.
But what about the equity markets? Both the US and International markets had some hairy years, but also some big returns during that same period. We often say that investing in equities is the only way to grow your money faster than the rate of inflation, but is that true even in extreme conditions? The S&P 500 returned an average of 5.2% over that same time period. The MSCI World Ex-US returned 8.7%. Returns were positive over that time period, although the US did not quite keep up with inflation as well as the International markets. This is another argument for global diversification, but we won’t go into that here. Long Term Government Bond performance had a return of 2.5%. Yes, bonds had an overall positive return during a time of extreme inflation, which initially drives bond prices down.
One more point as you look at the spreadsheet. We had a long period of time between 1982-2020, where inflation did not get to 5% one single time. Yet, we had equity markets that were extremely positive and negative during that time period. Inflation can cause some upset to the markets, but its effect is not predictable.
As I have said many times, sticking to a long-term philosophy that works over time and can weather all market conditions can sometimes be boring, sometimes be unnerving, but gives the greatest probability of success to financial futures.
Investors can focus on the daily rain clouds and sunshine the markets bring, or they can think about the long term instead. Check out the video below to see how weather conditions relate to long term investments.