Think Inflation’s Ending? Think Again.
October 06, 2022
Read Time 4 MIN
Market Remains Overly Optimistic on Inflation
A major asset class has returned 15% year–to–date, 13% over the past year, 60% over the past two years and 47% over the past three years. Typically, we would call that a bull market. However, because this major asset class happens to be commodities—the most under–owned and hated asset class of them all—it is an easy bull market to dismiss. But why? Because many gave up on the strategic importance of commodities in their asset allocation in the face of the seemingly never–ending Federal Reserve (Fed) fueled bull markets in both stocks and bonds. Most investors totally missed the inflation call, and many continue to double down on that upside–down bet of transitory inflation. Most ‘knew’ that we weren’t going to get inflation. Just as they now ‘know’ inflation will soon permanently subside.
When will inflation fall back to the Fed’s 2% target? The consensus view in the market is that inflation will disappear by 2024. We think that view is overly optimistic—at best. Thanos Vamvakidis, a strategist for Bank of America (BofA) Securities in the U.K., recently released a piece that’s making its way around Wall Street trading desks. It shows high inflation regimes typically take about a decade to resolve. His analysis concludes that, on average, inflation takes about 10 years to return to 2% once it exceeds 5%.1
Return to Normal? It May Take Longer Than You Think
At VanEck, our group is called Quantitative Investment Solutions—QIS for short. So, there’s no way that we could take a chart like this at face value without verifying the numbers. Surprisingly, we found that Mr. Vamvakidis’ results, just like the markets, paint too rosy of a picture of the future prospects for inflation.
Our main criticism is the start date. Mr. Vamvakidis started his analysis in 1980. This was already halfway through the last major global inflationary event. We corrected this by using data that went as far back as we could get—in this case, 1960. We also limited our analysis to G10 countries to avoid being accused of cherry–picking.
What did we find? Once inflation breached 5%, it took, on average, 18 years to fall to 2% or lower!
Number of Years for Year–Over–Year Inflation to Return to 2% (Following a Breach of 5%)
Source: Bloomberg, BofA Securities. Data as of September 2022.
Inflation: It Comes in Waves
The prior two major inflation regimes in the U.S. occurred in the 1940s and the 1970s. Both these events demonstrated that inflation is, typically, neither a linear nor an isolated event. Inflation is expected to come in waves with several different peaks and troughs. The inflation event of the 1940s lasted for a decade and had three major pricing surges. The great inflation of the 1970s saw a similar pattern. There were several inflationary surges and over a decade of price instability.
U.S. Consumer Price Index (CPI), Year–over–Year (%)
In our view, the best interpretation of these results is that once the inflation genie is let out of the bottle, it is tough to put back in. Will it be five, ten, or more years? Only time will tell.
Let’s Get Real, Folks
Investors should brace themselves for an extended period of rising and falling inflation, with a mean level significantly above the Fed’s 2% target. Real assets are a time–tested inflation hedge, so if you haven't already, you may want to consider them. The charts below demonstrate the asset allocation benefits of commodities during previous inflationary regimes.
Rolling 3–Month Real Returns When S&P 500 Declines
All eyes remain on the Fed. Surging interest rates on overleveraged economies globally have predictable results. We are likely heading into a severe and extended global recession. And the Fed is, finally, saying and doing the right things to combat inflation. Sadly, we believe we are too far down the inflationary path for a graceful ending. The economic shock will likely result in a systemic market event that requires liquidity to resolve. The recent market turmoil suggests to us that we are rapidly moving towards just such an event. Once again, the Fed will be forced to try to save the day. This time at the expense of inflation running significantly above its 2% target for an extended period.
In our view, the VanEck Inflation Allocation ETF (RAAX), a diversified inflation–fighting solution, presents a compelling investment.
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