Arnott: Are 401(k) Investors Fighting Yesterday's War?
In a high inflation environment, stocks and bonds will likely underperform other asset classes such as TIPS, commodities, and non-dollar assets. Table 1 shows the four major economic regimes and the asset class that performs best in each of them.
401(k) investors have not yet truly experienced an inflationary regime. The '80s, '90s, and naughts were generally low interest rate and low inflation environments, aiding stocks and bonds. Muted inflationary periods are wonderful for stocks and bonds. Stocks do well during disinflationary growth as low inflation reduces the discount rate that the markets will apply to future cash flows in determining the fair value of stocks. Low inflation also tends to be conducive to stable growth and is good for corporate profitability. Bonds are brilliant in disinflationary economic contractions as fears of the corrosive impact of inflation on bond prices wane.
So which asset classes perform best in high inflationary periods? Commodities when the economy is growing and TIPS when the economy is faltering. Commodity prices are pushed up by strong global demand; continued growth in emerging markets will likely fuel shortages of commodities. Like nominal bonds, TIPS prefer slower economic environments because they benefit from falling interest rates and lose value when rates increase.
We advocate the use of three pillars for our retirement portfolios: stocks, bonds, and inflation hedges. For investors who are confident that inflation will not be a serious issue in the coming 20 or 30 years, this can be a small pillar serving as an insurance policy in case they’re wrong. For investors who fear that our soaring debts will trigger inflationary shocks in the years ahead, this can be a large pillar serving to protect their purchasing power as inflation crushes the purchasing power of their mainstream holdings.
As we have expressed in past issues of Fundamentals, we believe that the long-term challenges from the “3-D Hurricane”—deficit, debt, and demographics—will lead to serious bouts of inflation in the years ahead.6 Investors should be positioning for a different economic regime now.
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