Grim yield to reap

Inflation may be less of a concern with the post-COVID-19 pandemic price jump a little more in the rear-view mirror each month.

However, the scars remain. Inflation of the recent past is now the new normal of everyday prices — be it groceries, vacation or borrowing to buy a home.

The bout of recent high inflation has also left investors with a new sense of uncertainty.

Bonds still offer portfolio protection against declining stocks after a negative economic “surprise,” says Robert Wilson, portfolio strategist and head of innovation at PICTON Investments.

“If the economy does much worse than expected, bonds tend to make money.”

That is the key idea underpinning the 60-40 portfolio — 60 per cent stocks and 40 per cent bonds — construction. When stocks go down, bonds go up. Over the long-term, that negative correlation helps smooths volatility providing steadier returns long-term for investor portfolios.

It has worked well from 2000 to 2020, “when inflation had the EKG of a potato,” Wilson says.

During those two decades, Canadian stocks fell more than 15 per cent six times, and each time government bonds outperformed cash by an average of nine percentage points, he notes.

This 20-year span, however, has created “recency bias” for investors, thinking this protective negative correlation works most of the time, he adds. Of course, it doesn’t all the time, with 2022 demonstrating how high inflation and rising interest rates can cause both asset classes to fall in value at the same time.

A longer historical view shows this isn’t an outlier outcome, Wilson says.

“From 1945 to 2000, we had 15 sell-offs of 15 per cent or more in Canadian equity,” he says. “Fifteen out of 15 times, government bonds underperformed cash on average by six per cent cumulative.”

Wilson argues that outcome is more likely to happen than the former.

That’s not to say cash is king for the next decade.

“Over the long run, it’s the lowest returning asset,” Wilson says. In the face of even low inflation — two per cent — a 1.5 per cent return from a high-interest savings account (HISA) is a real loss.

Only stocks provide a real long-term hedge against the threat of inflation, says Alan Fustey, portfolio manager with Bellwether Investment Management in Winnipeg.

“If you’re trying to stay above a real rate of return, which is your return minus the inflation, over the longer term, stocks have proven to be the best asset class.”

The trouble is on a short-term basis, stocks are volatile. And in the face of high inflation shocks, most stocks get hurt at least briefly because as interest rates rise, equities’ future returns have less value relative to their risk.

The upside today is “inflation is kind of yesterday’s story,” Fustey adds. It’s back to the Bank of Canada’s “Goldilocks” bandwidth of two to three per cent.

A little inflation is desirable. No inflation, or worse deflation — falling prices — often leads to a recession.

A risk of higher inflation remains, especially from tariffs. Investors today are more worried about slightly higher than normal inflation and slow growth. That’s stagflation, last seen in the 1970s, when broadly speaking stocks did poorly.

Stagflation has yet to emerge either. High hopes for artificial intelligence to make business more profitable has prevented that outcome so far.

Yet AI poses an inflation-like risk for portfolios.

Big tech — Microsoft Corp., Alphabet Inc. (Google), Apple Inc., among the other Magnificent Seven stocks — are borrowing hundreds of billions of dollars collectively to build data centres.

This is new. Prior to the AI craze, these companies carried little if any debt.

They made massive profits and still do. But their profits are now used to build data centre infrastructure — and those earnings aren’t enough. So they are borrowing unprecedented amounts.

“There’s a term in economics called ‘crowding out,’ where there’s only so much capital that’s available,” Fustey says. “So if a government or other corporations want to borrow, too, they’ve got to pay a higher interest rate to attract capital.”

The result is higher yields for bonds, a headwind to growth much like higher-than-desired inflation.

Some investments fare well in this environment, including cash. HISAs, for example, see their interest rates rise. Still, cash loses to inflation — just not as much as other assets.

Wilson notes alternative strategies such as market neutral funds can mitigate this risk. These strategies involve being long (invest in) stocks that do alright in rising rate environments and inflation (i.e. commodities and consumer staples), and shorting (betting against) those that do poorly (like utilities, technology companies and automakers).

He points to PICTON’s market neutral strategy outperforming cash by an average of 3.5 per cent for the last 20 years.

You can also plan to mitigate this risk without the complex investment strategies, says Herman Chan, certified financial planner and investment adviser with Crimson Financial in Toronto. “Look at the overall asset mix of your portfolio and your near-term needs.”

If you need investments for retirement income now or in the next few years, consider holding at least five years worth of cash needs, accepting inflation’s negative impact over that time.

Certainly, alternative strategies can be a good diversifier to portfolios, but the traditional mix of stocks, bonds and cash still works when contextualized to your situation, Chan says.

“Keep it simple, breaking down your capital into different buckets for different needs” he adds.

For the long-term, stocks are still the best for growth to outpace inflation. Bonds remain protective against a slowing economy in the medium-term, Chan says.

“And for short-term needs, capital should be parked in high-interest savings accounts.”

Joel Schlesinger is a Winnipeg-based freelance journalist

joelschles@gmail.com