High inflation won’t really hurt stock returns in the long run

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With inflation exceeding 7% for the first time in 40 years and the recent inversion of the so-called yield curve, many investors are left wondering whether they should change their investment strategy.

I don’t blame them. If we look at the data, it is clear that U.S. stocks have diminished returns following periods of high inflation and following yield curve inversions.

For example, when inflation exceeds 7%, the median return of U.S. stocks over the next year was 7.3%, compared to 10.3% when inflation was below 7%. And if we examine every yield curve inversion since August 1978, the median inflation-adjusted return of U.S. stocks was only 4.7% over the next year, compared to 9% during every other period.

Given this information, it can be tempting to reduce your stock allocation in favor of much safer U.S. Treasurys. However, any investor who followed this advice would have underperformed U.S. stocks, and sometimes by a significant margin.

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For example, when inflation exceeds 7%, the median inflation-adjusted return on five-year U.S. Treasurys was -2.6% over the next year, far below the 7.3% return on U.S. stocks during the same time period. And, following every yield curve inversion since August 1978, the median inflation-adjusted return on five-year U.S. Treasurys was 3.9%, compared to 4.7% for U.S. stocks over the next year.

This illustrates that investors looking to take advantage of this turbulent time won’t necessarily benefit by moving their allocation to U.S. Treasury bills.

Nobel laureates Eugene Fama and Kennth French came to a similar conclusion in a paper they published in July 2019: “We find no evidence that inverted yield curves predict stocks will underperform Treasurys for forecast periods of one, two, three and five years.” (Note: Fama and French developed The Fama French three-factor model, which highlighted that investors must be able to ride out the extra volatility and periodic underperformance that could occur in the short term.)

Given that shifting your stock allocation to U.S. Treasurys or cash isn’t the best solution, what’s an investor to do?

First, think about the long-term.

While high inflation can negatively impact stocks in the short-run, over longer time frames this relationship breaks down. In fact, the median inflation-adjusted return of U.S. stocks over the two years following periods of high inflation was nearly identical to the two-year return following periods of lower inflation (18.5% vs.18.7%, respectively). This suggests that those investors with a slightly longer time horizon need not worry about inflation’s impact on their portfolio.

Next, realize that this time could be different.

While it’s true that the inversion of the yield curve usually means that U.S. stocks will underperform and we will experience a recession within the next 12 months to 24 months, this isn’t always the case. For example, if you had cashed out of U.S. stocks following the most recent yield curve inversion in August 2019, you would have missed out on a 68% total return.

Finally, stay the course.

Though it can be tempting to make changes to your portfolio, the data suggests that most retail investors stay put during a panic. Yahoo Finance reported only 3% of Fidelity investors stopped contributing to their 401(k) plans and only 11% of Vanguard investors made any active trades during the market crash of March 2020.

Though it may seem like investors panic as economic conditions worsen, the data suggests that skittish investors are typically in the minority.

Nevertheless, if you are still feeling a bit worried about markets and macroeconomic uncertainty, I will leave you with some parting words from Jeremy Siegel, a world-renowned expert on the economy and financial markets and professor of finance at the University of Pennsylvania: “Fear has a greater grasp on human action than does the impressive weight of historical evidence.”

— By Nick Maggiulli, chief operating officer at Ritholtz Wealth Management



Source : CNBC