Another inflationary era at the worst possible time

Just as baby boomers are preparing to retire, Australia is gripped by high inflation.

Colonial First State’s new retirement report is reporting on the consequences. Australians are realising they’ll have to work a few additional years to cover the rising cost of living.

This is terrible timing. The baby boomers spent a lifetime paying off mortgages and then contributing to Superannuation. Australia’s retirement system is considered one of the best in the world as a result. And our housing bubble is legendary.

But what if our retirement plans are about to be hit by the worst possible conditions? The combination of inflation and poor investment returns. A rising cost of living that financial markets can’t keep up with. And a government that switches from supporting you financially in retirement to trying to save itself at your expense.

Not to mention falling house prices. But let’s leave that out for today and focus on stocks.

A decade of negative real returns is not
unusual in the stock market

Periods when inflation outpaces the stock market aren’t just common. They are quite normal.

This chart shows the US’ Dow Jones Industrial Average adjusted for inflation. It’s the index for which we have the best long-term data. And it shows something extraordinary.

Money invested in 1918 would’ve been worth less in 1982. That’s if you believe in the official inflation statistics.

Source: Macrotrends

[Click to open in a new window]

That time period is the most extreme long-term example of inflation reversing respectable returns. But neither of us is likely to retire for a period of 64 years. So let’s zoom in within that time horizon.

There were plenty of periods where US stocks fell, adjusted for inflation, for a decade or even more.

That’s the medium term. The one that matters for retirees. But it also includes devastating short-term shocks.

In fact, if you adjust for inflation, 2022 was the worst year ever for a 60/40 portfolio of US stocks and bonds. Yet retirees still had their cost of living to cover.

Selling assets during a crash leaves you with less exposure to the subsequent recovery. So the volatility matters a lot. Especially if you were presuming that bonds would be negatively correlated to stocks. They definitely weren’t in 2022. Both plunged.

It’s not just the US, of course. Adjusted for inflation, the UK’s FTSE100 trended down between 2000 and 2024. In fact, its only real surge was in the 90s.

Our ASX200 has only delivered poor returns since it started in 2000, once you adjust for inflation. The All Ords have only outperformed inflation by 2-3% per year since 1980 too.

Within that time period, Aussie stocks often went nowhere for long periods. Adjust for inflation and investors were falling behind terribly. Morningstar explained this back in 2018:

Inflation can cripple real returns for decades. For people who follow the traditional ‘buy and hold’, ‘set and forget’ approach to investing, it is sobering to see that the broad market index in Australia (the All Ordinaries and its predecessors) is just 24% higher than where it was 50 years ago in August 1968.

The market hit a mini-high on 16 August 1968, and then went on to peak at the end of 1969 at the top of the nickel boom, which also lured in many thousands of first-time investors. It promptly crashed and took 46 years to finally get ahead, in March 2016.

Recent returns have been better. But the inflation surge of 2022 and pandemic crash added to the pain since.

The list of examples goes on, around the world.

And this is before the fees and capital gains you had to pay on inflation-driven fake returns.

The only true outperformance came from compounding dividends. On which taxes must also be paid, making those returns tax inefficient.

Again, the long-term poor performance in our stock market hides what’s important. It included numerous medium-term periods when investors underperformed inflation for many years.

That could happen again. Destroying the retirement plans of millions.

But if you can’t dismiss the chance of a high inflation and poor returns period during your retirement, what would make me worry about one today?

Inflation is the easiest way out for politicians

Inflation isn’t something that just happens. It is a deliberate and targeted government policy. The purpose is to reduce the real value of government debt.

Early baby boomers experienced this for themselves. The real burden of their mortgages was inflated away in the 60s and 70s. Governments today want to inflate away the burden of their debt, just as they did in the past.

To be perfectly honest, such inflation may be the best option in many countries. The level of austerity and tax hikes required to bring deficits under control could cause far worse political crises.

But investors shouldn’t make value judgments. We should react to what’s likely to happen.

When governments use inflation to devalue debt, the devaluation harms three groups of people. Those lending to the government, those living off investment income and consumers. That’s retirees on all three counts.

Wages can keep up with inflation better than other sources of income. And it’s not just government debt that gets inflated away, but all debt. This helps those with mortgages. So workers and the mortgaged middle-aged suffer proportionately less under inflation.

I believe this is why central banks were so slow to respond to inflation in 2021. They were trying to inflate away some of the government’s pandemic debt.

But the point is that inflation is likely because we need it to avoid a fiscal crisis.

How inflation swindles the retirees

If you want to position yourself to benefit from inflation instead of suffering under it, you need to understand its impact on the stock market.

This is not as simple as it sounds. Warren Buffett’s famous 1997 analysis ‘How inflation swindles the equity investor’ explains the nature of the problem:

For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms; let the politicians print money as they might.

And why didn’t it turn out that way?

The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon?) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough.

But anyone who examines the aggregate that have been earned by companies during the postwar years will discover something extraordinary: The returns on equity have in fact not varied much at all.

Buffett’s main point in his essay is that stocks can outperform bonds during periods of inflation. But only if certain complex conditions are met. And outperforming bonds during inflation doesn’t mean outperforming inflation.

Today, the conditions for stocks to outperform are not met in many stock market indices. They are not full of companies that invest in physical assets using a lot of debt. We’re noticeably bereft of aluminium smelters and production lines in the West.

Also, our stock markets are very overvalued by many measures. We are going into an inflationary period with conditions that suggest underperformance. Inflation will be what hides this underperformance. While delivering nominal capital gains, the government can tax.

The point is that a stock market crash is likely baked in alongside the poor inflation-adjusted returns.

There are, of course, some sectors that will do well. Back to that in a moment.

But the point is that Australia’s stock-market heavy retirement system is overexposed to an asset class that has a history of underperforming inflation for long periods of time. And we’re likely in for an inflationary era.

Those who see inflationary eras coming can actually benefit from them

We face an inflation-adjusted era at the worst possible time for retirees.

They hold overvalued assets that are unlikely to protect them from inflation and a government that will go from helping to hindering them.

You need a plan to overcome these headwinds.

Every economic era has its winners. And, like I said, a period of high inflation is hardly unusual.

What outperforms during such periods?

That’s easy. These commodities.