Morningstar - Q4 2020 - 12

Dispatches

What If Inflation Isn't
Dead? Cash fares
surprisingly well as a
hedge, if the Federal
Reserve obliges.

IVORY TOWERS

John Rekenthaler

The last time that inflation was this dormant,
Neville Chamberlain began the year as the
United Kingdom's prime minister and three cans
of Campbell's tomato soup cost $0.25. The year
was 1940, and not only had inflation not reached
4% during any calendar year of the previous
two decades, but eight of those 20 occasions also
suffered deflation.
Although recent years haven't featured deflation,
save for 2009, today's low-inflation streak
is even longer. Not since 1991 has calendar-year
inflation surpassed 4%. Consequently, the
market's inflation expectations, as implied by
Treasury yields, are at an all-time low. In the early
'40s, payouts on 10-year Treasuries bottomed
at just below 2%. That note's yield was below
0.70% in early September.
That investors have become nonchalant about
inflation may be witnessed by the distinctly muted
reaction to the federal government's recent
stimulus efforts. In 2009, an $800 billion recovery
bill prompted widespread unease about
growth in the federal debt. In contrast, this year's
$2 trillion CARES Act, accompanied by the
suggestion of an additional stimulus bill, has
elicited few complaints.
Another perspective: The Congressional Budget
Office forecast that the United States will
run a $3.7 trillion budget deficit in fiscal 2020,
which represents 18% of expected gross
domestic product. That will almost double 2009's

12

Morningstar Q4 2020

shortfall, as measured by that same ratio of deficit/
GDP. That 18% figure has been exceeded in
modern U.S. history only by the World War II years
of 1943, 1944, and 1945, and barely at that.
Rising national debt no longer seems to trouble
bond-fund managers. Those who fussed
about such things have been chased out of the
business, replaced by pragmatists who cannot
explain exactly why what they learned in
their macroeconomics classes no longer applies
but who know what happens to investment
managers who habitually underperform their
peers. Let economists sort out the theories;
fund managers have a job to do and shareholders
to satisfy.
This approach may continue to succeed. If
investment professionals struggle to understand
why inflation remains so quiet, far be it from
me to provide the answer. Nor am I terribly
concerned that the marketplace has become so
complacent. While the popularity of bonds
triggers my contrarian impulses, I have learned the
hard way that sometimes the crowd is correct.
For example, 10 years ago critics disparaged
the development of a "bond bubble" based largely
on the premise that all those individual investors
couldn't be right. So far, they have been.
Wartime Economies
Perhaps 2020 will later be recognized as the
turning point, the year when inflation was finally
rekindled. So far, that has been anything but
the case. The bond markets have been delighted
by the worldwide slowdown created by
the appearance of the coronavirus. That reaction
certainly makes sense for the near term. With
spending depressed and global economies
shrinking, inflation is currently but a concept. It
will be a while before prices can increase.

However, warns my friend Bill Bernstein, when
the coronavirus is finally subdued, danger may
await. The analogy is of a war economy. While the
battle against COVID-19 is metaphorical, as
it is waged with social distancing and ventilators
rather than tanks and drone strikes, it resembles
a wartime activity in that resources have
been diverted. Consumer spending is depressed,
and, for those who have retained their jobs, assets

are accumulating. Eventually, per the wartime
thesis, this pent-up demand will explode, thereby
sparking inflation.
That certainly has occurred in the past. Inflation
in the United States exploded after World
War I, then again after WWII, and then again after
Vietnam. (The latter, admittedly, was greatly
exacerbated by the oil crisis, which was a
separate and distinct problem.) The lone exception
among the past century's four major conflicts
was the Korean War, although inflation briefly
spiked a couple of years after its conclusion before
once again subsiding.
The analogy, to be sure, is imperfect. While
wartime economies typically bring increased
employment, the COVID-19 pandemic has
sidelined workers. Global economies are slack,
as opposed to stretched by the addition
of wartime projects. Nor, for the most part, could
the world's COVID-19 response be classified
as a figurative version of total war. Only a
small portion of the global economy is being
employed against the pandemic.
Nonetheless, the resemblance is sufficiently
strong to merit concern. Also worth
considering is that eventually, global developed
governments may decide to inflate their way
out of their national debts. They did not
make that choice after the 2009 financial crisis,
but debt levels were lower then. For example,
in 2010, the United States had a debt/GDP ratio
of 54% as opposed to 101% currently.
Practical Implications
As a reminder-this being familiar territory-
the best assets for an inflationary environment
are cash, inflation-adjusted bonds, and
commodities. Equities aren't as attractive but
neither are they terrible because over time
corporate earnings tend to rise with inflation.
Then come junk bonds and finally, at the
bottom of the list, the high-quality bonds that have
performed so well in 2020.

Three modifications can improve a portfolio's
inflation resistance: 1) moving high-quality
bonds for cash and/or Treasury Inflation-Protected
Securities, 2) shifting some assets from equities
Morningstar - Q4 2020

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