When we last met Professor Campbell Harvey of Duke University in May 2020, he was upbeat amid the torment of the pandemic and the gloom.
Harvey, whose negative yield curve model had a perfect track record of predicting recessions, said a vaccine—at the time a speculative possibility—would deliver Strong economic recovery and new market heights.
Now that that’s happened, he’s seen inflation come back, and not just temporary, a new paper he wrote with four other researchers shows.
In this Q&A, he discusses the impact on stocks and bonds, and tells The sectors most affected Which can be good hiding places. Harvey Professor of Finance at Duke University’s Fuqua School of Business.
Howard Gould: The economic recovery looks much stronger than expected, and people are talking about inflation, which brings us to your paper. Do you expect to see inflation and do you expect it to be temporary or long-term?
Campbell Harvey: It is clear that inflation risks have increased. When I say “inflation risk,” I mean, the risk of inflation is higher than the level we are comfortable with. Inflation can go up 3% and that can be good news if you start at minus one. You can go from minus to two, and that’s basically the economic engine getting faster. As you move from the age of two to five, you start to worry. We all know that inflation, once it reaches a high level, is a painful thing to control.
We haven’t really had inflation in 30 years, so most investors wonder why the Fed thinks this is such a big deal, because they don’t remember what happened in the early ’80s. It’s hard to imagine 20% interest rates. It’s hard to even think about that because the rates are so low today, but we’ve been through that and it’s been a long time. Of course, there are some countries that have experienced bouts of hyperinflation, such as Zimbabwe and Venezuela.
Go: This is hyperinflation, though.
Harvey: We are not Venezuela. No need to worry about that. However, what are the risk factors here? Well, number one, you have a massive increase in the Federal Reserve’s balance sheet. You might say, “Well, that also happened during the global financial crisis and we didn’t really see a spike in inflation.”
That may be true, but I wouldn’t be too comfortable basing major decisions on a single note. The second thing is that we run into, in 2020, a double-digit deficit and in the CBO projections it’s another double-digit deficit in 2021. This will be the first time this has happened since World War II. You put those two things together and the danger increased.
Go: Do you think we will see a bout of sustained inflation or are these just temporary bottlenecks?
Harvey: It is really important that investors understand it. First, what affects asset prices is the occurrence of long-term inflation surprises. If you expect [temporary price increases] To be reversed, it will not necessarily have a significant impact on asset prices. What we see today is actually, in my opinion, a combination of two things. We’re seeing some purely temporary inflation, some supply chain issues. These problems, for example, cause the prices of timber or other commodities to rise to extraordinary levels. These levels are not likely to be permanent, and there will be some pullback from those levels.
I also think that there is something to what we see today is a readjustment of the long-term outlook. The cleanest way to find out is the derivatives markets as well as the breakeven inflation of Treasury Inflation Protected (TIPS) securities. We have certainly seen an increase in these expectations throughout the year.
I don’t think it is at all unreasonable that by the end of 2021 inflation will be at an all-time high, or perhaps even cross the 4% threshold.
Go: 4%? By the end of this year? As measured by the Consumer Price Index (CPI)?
Harvey: Yeah. This is fundamentally different from the ideal point of 2%. I think we’ll be over 3%, maybe in the 4% range.
Go: On Thursday, the government reported that the consumer price index had risen 5% over the past 12 months ending in May. Is this, or something close to it, what we can expect to see for the rest of 2021?
Harvey: The numbers we’re seeing are a mixture of temporary and long-term effects. Some price increases will be reversed. However, other drivers, such as housing costs and rising wages, are long-term in nature. I reject the idea that we can discount the highest level of inflation in 13 years because it is the result of “base rate” (starting at a low point) and temporary effects. I still think the 4% forecast is trustworthy.
Go: I said in the newspaper that 5% is the real risk. And when unexpected inflation exceeds 5% per year, stocks and bonds perform poorly.
Harvey: When we start again from the moderate level and cross the 5% threshold, historically, my research paper, using 95 years of data and eight different episodes within the US, historically hit stocks. We showed that they lost 7% [annualized] based on the rate of inflation.
Obviously, if you invest in bonds, if inflation increases, interest rates will go up and the value of the bonds will go down. The longer-dated bond, the 30-year bond, is very sensitive. They are risky now, [because with] With a 1% increase in the interest rate, you could lose 20% on a 30-year bond.
If you’re thinking of an average portfolio made up of 60% equity, 40% fixed income, you get it on both sides in case inflation rises.
Go: Almost every sector that I looked at, except for energy and perhaps health care, has done very poorly.
Harvey: The worst possible sector historically is consumer durables, which are losing 15% year over year. The energy and healthcare sectors have really small negative returns, like -1%. The simple thing to do is say, ‘Okay, let’s take a look at the stocks in my portfolio, well, I’m actually a lot heavier towards consumer durables. I’d probably like to change the allocation and maybe include some healthcare, for example, which is characterized by historically very flexible. Simple things like portfolio rebalancing, maybe with individual stocks or sector ETFs, and maybe you just want to rethink the sectors you’re exposed to. It is immediately applicable to any investor. It doesn’t matter if you are an individual or a large institutional investor.
This is a good time to look at your sector exposures and think about rebalancing. You can do a rebalancing and inflation may not rise. This does not mean that you made a mistake. Maybe if you kept your original assignment, you’d make 1% or 2% more, but that’s just the insurance cost. This is a simple thing to do.
Go: I’ve found that small stocks tend not to perform well during high inflation. Now, small stocks have done very well over the past year or so. Should people with small stocks also move to larger stocks, or value for money growth?
Harvey: Small stocks are at risk. Again, you might consider reevaluating your ETF portfolio. ‘Quality’, which has different definitions, tends to perform better in cases of inflationary increases, [and] carry its own value. Again, this is better than taking a -7% hit.
Go: During high inflation, TIPS is intuitively the best option, but the Fed has been buying tens of billions of dollars from TIPS in its bond-buying program. Has this distorted the market and made it less attractive to hedge against inflation?
Harvey: The tips actually offer an inflation hedge by building. It is indexed by inflation. However, they are expensive: in periods of non-inflation, you will have a negative return given where we started. I’m not giving investment advice, so I need to be careful here, but let me just say that TIPS is an expensive way to hedge against inflation, other things are much more obvious like rebalancing your portfolio towards more resilient sectors of the economy. [the face] from inflation.
Go: What about the goods? Buying is a little more difficult for retail investors. And if you buy Standard & Poor’s materials sector
violence against Woman
This doesn’t really do the job, does it?
Harvey: When we look at commodities, we are looking at commodity futures, which is not something that is easy for a retail investor to come up with. We also show that buying stocks related to commodities, for example, instead of buying oil futures, you can buy stocks of an oil company, and it doesn’t offer nearly the same kind of protection, but it’s not bad. There are ways for individual investors to access commodities through some ETFs, but it’s not as easy as making a simple rotation of the stocks in your portfolio.
Go: You said in your paper that the inflation protection attributed to gold comes from a single event in 1979. How many thousands of years has gold been around and all people hang their hats?
Harvey: The problem with gold is that it is volatile and inflation is not volatile. Gold is an unreliable hedge for inflation surprises. In our paper we [looked] With unexpected inflation and gold’s hedging ability, we saw that it was largely driven by the 1979 observation. In this new paper, we take a look at gold’s performance in different periods of inflation. During these inflation spikes, gold was already in good shape, but it was still heavily influenced by this single observation from 1979, [although] They provide some protection.
Go: What about crypto and bitcoin?
Harvey: In theory, bitcoin
Supply is separated from the economy or any money supply. It is just purely an algorithmic role and the last bit of bitcoin is minted in the year 2140. You can make a theoretical case that since there is no direct correlation with money supply or monetary policy in any developed country, this is a potential hedge.
There are two main drawbacks here. Number one, history is limited. We have high quality data from 2013. We have no experience with Bitcoin’s full history of rising inflation, [so] Basically no track record. The second drawback is that I mentioned that gold was unreliable because it was volatile. Well, cryptocurrencies are six times as volatile as gold.
Go: Six times more volatile than gold?
Harvey: We have seen inflation increase recently, perhaps unexpectedly, to [5% in the 12 months ending in May] And what happened to Bitcoin? decreases by 50%. It is this type of volatility that makes it very likely that a cryptocurrency like Bitcoin will not be a reliable inflation hedge. Bitcoin prices are mainly driven by risk/no risk. In March 2020, we saw the stock market drop 35%, and bitcoin fall 50%. Then the stock market hits a record high, and bitcoin hits a record high. Again, it is a speculative asset. To think, “Okay, I’m going to load my wallet with cryptocurrencies because they hedge against inflation,” this is a purely theoretical argument that ignores some basic things like volatility.
Go: We’ve seen GameStop
took off two months ago, the AMC
lately. What do you think of the market where “meme” shares like this have suddenly gone up?
Harvey: Fintech has made it a lot easier for individual investors to be active in the stock market. They can buy fractional shares. They could have an account with Schwab
Or Robinhood, and these investors aren’t full-time. They rely on sometimes inaccurate information on Reddit and places like that. We have seen a steady decline in the share of retail investors and overall market activity. It’s down to about 10% in 2019 which is basically 15% in 2020 and probably 20% in 2021.
[So,] If you think that what happens to GameStop or AMC is only because of the retail investor, then that’s not true; Many institutions and hedge funds are active in this market, taking advantage of this volatility. Basically, we see [large] Deviations from the base value. This creates opportunities for other investors to take advantage of it. This is not without risk, but in my opinion, what we’re really seeing is that at least in the short term, some markets become less efficient.
Howard Gould is a columnist for MarketWatch.
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