May 20, 2021

Episode 150: The Ultimate Inflation Hedge

May 20, 2021

Is it possible to hedge your investments against different levels of inflation? This is the question we ask in today's episode, as we run through a variety of different investment approaches and commodities. While the answer may not come as a huge surprise, it is definitely worth the walk-through and getting to grips with what the literature can tell us in each scenario. After rounding up some news and a few reviews relevant to our usual subject matter, we dive straight into this topic, tackling the performance of stocks and bonds, gold, international stocks, value stocks, and more! We also share some general thoughts and questions to ask during periods where inflation is high, before positing our view that there is no single successful hedge against inflation, but rather our usual position of an adjusted and diversified portfolio will serve you as well in this regard as in others. We finish off this episode with a few of our usual quick cards, and this week's disturbing bad advice! So tune in to hear all about what you should know about expected and unexpected inflation and a whole lot more!

Key Points From This Episode:

The exciting recent decisions around succession that were made at PWL! [0:00:22.4]
Ben's review of Greg McKeown's new book Effortless and Netflix's Money, Explained. [0:04:51.7]
A quick round up of some big money news from around the country. [0:08:25.2]
Reflecting on the recent performance of Wealthsimple portfolios. [0:13:26.6]
'The ultimate inflation hedge'; looking at returns under different conditions through the years. [0:19:50.1]
Looking at the performance of stocks and bonds during high inflationary periods. [0:25:04.6]
What to do and what to ask in situations with higher-than-expected inflation. [0:32:21.0]
Weighing the value of gold as an inflation hedge; 'The Golden Dilemma' and 'The Golden Constant'. [0:39:50.3]
The performance of international stocks during a period of high inflation. [0:44:05.8]
What the research shows about value stocks and and their relation to inflationary periods. [0:45:55.2]
The answer to the question: no perfect hedges against inflation! [0:52:04.7]
Today's cards; saving versus spending, and tools versus treasures. [0:55:20.3]
Bad advice of the week courtesy of the Investment Executive! [0:56:56.0]

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We're hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Perhaps, off the top, we can talk about the business news that we shared in the community last week. It's not my default nature nor yours to share news like this, but since the feedback was so positive, we thought we would quickly just share with everyone that our company went through at reorg on May 1st, which has been a long time in the planning, and it was very important for us to do this to maintain independence with a long, what we're calling a hundred year vision. That was really important to us. That's what enables us to design our service set for clients, it allows us to do things like a podcast without having, perhaps a private equity or a publicly traded company driving what we do. We control what we do. We always have, and it's been great, but it was time that we solve the succession plan for the company.

With a retiring founding shareholder, we were able to pull this off and enable us to build our own long-term ownership and leadership plan. I mean, you and I are pretty good. We are a good example of that, like you are the next generation. You represent the next generation of the company with lots of people like you. Now we'll be able to systematically transfer that ownership and leadership to the next generation. It's something, I think, we're all very pleased with here at the company. It's very important to maintain private ownership, and it's super exciting to see what this can become given the talent that we have in this group.

Ben Felix: It's a big deal, like the way that you just described it, I don't know if it does justice to how big of a deal it is, the succession process in many businesses. But I mean, maybe just because I know it best, but the financial advice business in particular, succession is not easy. You see, like you kind of alluded to it, Cameron, you see, in many cases, what happens is the founding partners sell out to a private equity firm and that's just what happens, but it changes the nature, in our opinion, it changes the nature of how you can operate the business. Being able to pull this off without private equity, yeah, it's a big deal.

Cameron Passmore: In fact, there was an article, I think in The Globe and Mail two days after we announced it, talking about exactly this, like I am the typical, call it founding advisor, right? Mid-50s neural person that kind of built it, but what it takes to get it here is different from what it takes to grow from here if the goal ... And this is about what we wanted. That means selling out to a bank or private equity, if that works for you, that's fine. It's just not what was important to us. This allows us to do what we think is best for us.

Ben Felix: Yeah. So, it's big news. We're all very excited about it.

Cameron Passmore: For sure. You want to do a quick review?

Ben Felix: Yeah. We had a couple of nice reviews. I'm just going to read one of them in the interest of time. We do read all of them though, whenever they come in, so we appreciate the reviews that people do send. This is from We Design, and they said, "I've learned so much since listening to Ben and Cam. I first started with Ben's YouTube channel and guided me to learn more about MPT and factor investing. Now I've listened to 30 or so of the latest episodes, and I'm slowly going back listening to every single episode. It's the perfect podcast too, if you want to learn about making rational financial decisions or hear from the brightest minds in the world of finance. "

That's not us, by the way. That's the guests, I think, they're referring to. "I only wish they could clone themselves and make content more geared for you as listeners. Keep up the amazing work." Very nice. Very nice comments.

Cameron Passmore: Yeah. We're well over 500 reviews as well, which is very much appreciated.

Ben Felix: Yeah, it is very cool.

Cameron Passmore: Something new too, that we're going to do, I was just talking to Angelica is, if you happen to have bought some of our merch, we would love to see you post pictures wearing the merch, or the water bottle, or the mug, or whatever, if you happen to be traveling, if you're able to travel or at a barbecue. I think Angelica today is posting a picture of my daughter's boyfriend. So, they did a barbecue last night. They did their own ribs on the barbecue. Pretty cool picture that they're going to post. Well, we'll even post it on Instagram @rationalreminder anytime now.

Ben Felix: Awesome.

Cameron Passmore: You can connect with us there. Check out your bots on the Instagram page. CP313 on Peloton, or #rationalreminder, if you want to do some rides with us, I'm on Goodreads, both of us are on Twitter, easy to find us.

Ben Felix: All right.

Cameron Passmore: Anything else, Dad?

Ben Felix: No, let's go ahead to the episode. Welcome to episode 150 of the Rational Reminder Podcast.

Cameron Passmore: Quick book for you. It's funny, and lots of comments about how many books I read. It's really not that many, and I'm sure lots of people who are saying these kinds of things read just as much as I do.

Ben Felix: I don't. I wish I did.

Cameron Passmore: don't know. I'm not sure about that. Anyways, this is a book, so I read, and we mentioned last year, Greg McKeown's book, Essentialism, which I loved. He had a new book come out recently called Effortless, which I'm halfway through. Honestly, I'm not sure I'll finish that. I'm not crazy about the book. I loved Essentialism last year, but this book called Effortless is ... I don't know, it just doesn't work for me. I mean, it's good. It's worth reading. I'm just not crazy about it. But the point of the book is that, the effortless state is, as he describes, a point where we are arrested emotionally unburdened and fully energized, high awareness, you're present in the moment and focused on what is important in that moment.

He talks in the beginning about, instead of asking why things are so hard that maybe you should invert it and ask, what if this could be so easy? Great, I understand it. It just doesn't do it for me. This is what he says, "Enjoy the fact that work and play can co-exist and then turn menial into meaningful habits. Let go of the burdens that you don't need to keep on carrying and focus on what you have and what you bring to the table and be thankful for that." Again, it's all very, very nice. Just I'm not wild about the book, and that's my first quasi negative review of a book I've had.

Ben Felix: It reminds me a lot of the discussion that we had on happiness, not that long ago on the podcast though. We talked about states of flow. I don't know.

Cameron Passmore: Yeah. He talks about rediscovering the art of doing nothing, rest, take an effortless nap. Be very aware of the power of being present, the benefits of training yourself to focus on the important and ignoring the irrelevant, and to see others more clearly, park your emotions, park your judgment, park the drama. That's something we work a lot on in the team and try to put the other person's truth in front of your own truth, and then also clear the clutter in your life, kind of rekindle your life.

Ben Felix: Yeah. I see bits and pieces in there from a lot of the different social psychologists that we've spoken with over the last few months.

Cameron Passmore: I said it was worthwhile. I just said I didn't enjoy it.

Ben Felix: I'm not going to read it. If you say you didn't enjoy it, then I will not enjoy either.

Cameron Passmore: I loved Essentialism, so if you read one of them, go read Essentialism. I saw our friend Hal Hershfield last week on LinkedIn talked about a new series that he was part of on Netflix, so we watched a couple episodes last night. This is a new series called Money Explained. It's a five episode series. Just released actually, and the episodes are really short, 22 minutes each. There's one on get rich quick, credit cards, student loans, gambling and retirement. Hal is in the credit card one and the retirement one, so we watched the retirement one last night. It's really well done. Great graphics, straightforward points. He talked about how the impact of viewing the future self impacted.

He talked a lot with the evidence in the show that he mentioned with us when he was on the podcast, and how, when you frame how you view yourself now, how you view a stranger now, how you view a stranger in the future, and how you view yourself in the future, when you go through this and there's techniques that can be used to get yourself to view yourself in the future, which will help you make more active decisions, and how that will impact your future. It was really good. It was really, really, really well done, so I highly recommend that. It's called Money Explained on Netflix.

Ben Felix: Maybe I'll watch it. I don't think my wife would be that interested though, and I only ever watch Netflix when I'm sitting with her on the coach.

Cameron Passmore: Yeah, at least I wasn't crazy about it . One quick, quick news story, DSE is dead, deferred sales charge is dead. Ontario finally-

Ben Felix: Yeah, in Ontario.

Cameron Passmore: OSE, Ontario Securities Commission finally acquiesced and will join the rest of the country's regulators effective June, 2022. The last pointed debate on that was, would that limit access to some Canadians with smaller portfolios? Because a lot of that was funded by the commission paid for by the deferred sales charge, but they finally gave in and matched up the rest of the country.

Ben Felix: The resistance was pretty ridiculous. We're seeing so much of the other advice models starting to proliferate in Canada, and this should just accelerate that.

Cameron Passmore: For sure. Technology is going to go a long way in helping that.

Ben Felix: True.

Cameron Passmore: Another quick one, marriage no longer revokes a will in Ontario. That's pretty big news.

Ben Felix: Yeah.

Cameron Passmore: That's something that comes up all the time. It used to be that when you got married, any prior will was null and void. It's no longer the case. So, Bill C-45, which received Royal assent changes this, and it also makes virtual will witnessing valid permanently. So, you can now seek out a lawyer anywhere in the province.

Ben Felix: Yeah, that's awesome.

Cameron Passmore: That's awesome. At least one of the witnesses must be a licensed lawyer or a paralegal, but again, opens up the whole province to you. It also gives courts the power to save wills that might otherwise have been found invalid due to some sort of technical error, that there is an error, if a will seem to be invalid, the estate property would be distributed according to and test the C rules rather than the wishes of the deceased. Apparently, it's another victory. Again, this isn't legal advice. This is widespread news, but thought it'd be worth sharing here. Now, you want to follow up on Wealthsimple.

Ben Felix: Yeah, so in episode 98, we spoke about, Wealthsimple head. They did in 2019, they redid their portfolios. At the biggest addition, if I remember correctly, it was adding long-term bonds, maybe some low-vol stocks into the portfolios. When the pandemic-related stock market decline happened, they wrote a piece, I couldn't find it the second time around here, but they wrote a piece sort of celebrating the fact that their portfolio changes from 2019 were very effective in dealing with the downturn because the long bonds, as people may or may not know, I guess who watches long bonds? I do.

But last year long bonds, when things were really crashing, that as part of the response to the pandemic, we saw interest rates decline, which made the prices of long bonds go up pretty substantially. So, if you're holding long bonds when stocks crashed last year, you did pretty good, relatively speaking anyway. Wealthsimple came out with a piece sort of celebrating the fact that their portfolio changes had been able to deal with the downturn quite nicely, and we did a whole segment of an episode in episode 98 talking about that, talking about the fact that they were doing a victory lap for this thing that happened, and why it may not actually be something to celebrate.

Something that I've noticed this year, and this is just casually from being on Reddit, on the personal finance Canada subreddit, seeing people talking about their experiences with Wealthsimple. People are noticing and discussing the fact that Wealthsimple has been somewhat, at least compared to VGRO, they've been somewhat active because they made those changes in 2019, and then again in 2020, they made some other changes, where they, I'm no expert on their portfolios here, but I think they added gold. I know they added gold because that's one of the things I'm going to talk about here. I think they had a more long bonds at that point. I took a quote from somebody on Reddit that was talking about this, there's a whole thread discussing it.

But somebody said, "This is why I left Wealthsimple two years ago. They kept changing assets to buy every few months. It wasn't passive at all. No surprises with Vanguard, all-in-one now." It's interesting, right? Because at the onset, the robo-advisor pitch was listen, we'll make a globally diversified rebalanced portfolio of index funds really easy for you. At that time, that was a big deal. Like when the robo-advisors first launched, but then it wasn't that long after that the all-in-one ETFs started launching, and all of a sudden, what's the value proposition of the robo-advisor platforms? Harder to define, I think.

Not that there's not value, and they're starting to offer other services now, like financial planning and access to other services, but changing the portfolio saying, hey, let's be different from a cap weighted index, that's part of the value prop or it can be. I'm not saying that's why they made that change. I don't know. I think they probably did it because they think it's going to improve the risk adjusted returns to the portfolios, but it does also make them different from an asset allocation ETF. One of the things that I wanted to look at was what's been going on this year because the other conversation I've been seeing happening on Reddit about Wealthsimple is that, returns this year, and year to date returns don't matter. We know that, but it's still fun to talk about.

People have been talking about Wealthsimple's returns this year not being very good, being pretty much flat. Well, the market's, a globally diversified portfolio of index funds, for example, has been increasing pretty substantially. Right now they have 16.5% of the 80s portfolio in Wealthsimple, the Wealthsimple growth 80-20 portfolio holds 16.5% long-term Canadian government bonds. A year to date, that holding is down 15% as it May 14th.

Cameron Passmore: That's 16.5 of the 20% fixed income?

Ben Felix: 16.5% of the overall portfolio, so most of the fixed income.

Cameron Passmore: Okay. That's what I mean. So, 16 of the 20 is like 80% of the 20 is in long bonds.

Ben Felix: You got it.

Cameron Passmore: Interesting.

Ben Felix: So, that's pulling down. Stocks have done quite well this year, but the fact that the long bonds have not done so well is putting downward pressure on their overall returns. Now, I mentioned they made a second change, so the two changes in recent history, the 2019 change and then in 2020, they made a second change to add gold, and on their website, Wealthsimple has a little explainer for why they did that. So, in answering the question, why have you added gold? They say, "Gold has a reliable relationship with inflation over the very long-term. We hold it to replicate the inflation hedging parts of our fixed income allocation that no longer offer the potential for diversification or return. The gold holdings we've added are a very small part of our portfolio." It's interesting. It'll become more interesting when we get to the main portfolio management topic today about how to deal with inflation, because I talk about gold in there too.

They used GLDM, which is an ETF at the end of August, 2020. Now, I'm not 100% sure on the timing there. That's based on somebody on Reddit posting that Wealthsimple just emailed them about this change, so I don't know if that's exactly the right timing, but roughly, because Wealthsimple did announce it as a Q3 change to their portfolios. From the end of August until May 14th, 2021 GLDM is down more than 13% and year to date, so just from January until May 14th, it's down 7.75%. Again, pulling down the returns.

Then the other thing that they did and that they celebrated when the market declined is that the low volatility stocks were a big help. But again, if we look at EEMV, which is the emerging markets low vol holding that they have, it was down 2.6% year to date, and XEC, which is just a cap weighted emerging markets fund is only down 1.78% year to date. Then ACWV, which is a global low vol fund is up 0.36% year to date, while ACWI, the just cap way to total market equivalent, is up 3.5% year to date. Lots of tracking error from the things that helped last year, which is ... It's interesting.

It's also worth, just on low-vol hearing, if you haven't, hearing what Robert Novy-Marx had to say about it in his Rational Reminder episode. I tried to look at the overall performance. Now, this is me recreating the performance based on the current allocations, so it should be close to what actually happened. But as at the end of April, my overall portfolio software doesn't let me go to, the most current data is by month, so at the end of April, based on the current allocations, the 80-20 Wealthsimple growth portfolio is up about 1.28% year to date, net of fund fees and 50 basis points management fee.

So, 1.28 net of all fees. Then I compared that to a couple of different things. I compared it to the Rational Reminder 80-20 portfolio, which is up 6.36% over the same period, and I compared it to XGRO, so just to cap weighted ETF, it's up 5.07% over the same period. Now, again, we're talking about year to date, this is a few months of performance, four months of performance. What does that tell you? Probably not much, but I guess I'm just addressing the comments that I've seen people making on Reddit about, why is my Wealthsimple portfolio not doing that well with marketers? That's the question we're answering here.

Not saying it's good or bad as a long-term allocation, although we did say it was not so good when we talked about this in episode 98. I also looked at the DFA 80-20 portfolio, just because when I was looking at the numbers, I thought I'd take a peak. It's actually up 9.14% year to date over the same period, so up a lot more than even the rash reminder portfolio. I think that's largely, the tilts have been paying off for sure, the tilts toward small cap and value. Currency hedging has also been paying off though, because the Canadian dollar has been strengthening. All of the other portfolios, I think Wealthsimple's got a bit of hedging, but the DFA 80-20 portfolio, the non-Canadian equities are about 40% currency hedged.

That's been a bit of a headwind for dimensional. I also wanted to look at, what if we push this back to September when they made the change into gold, because it was the end of August. So, look at starting from September, the Wealthsimple portfolio is up 7.87% over that period, the Rational Reminder 80/20 portfolio is up 15.47%, and XGRO is up 12.7%. Again, and we saw earlier like long bonds did poorly over that period. Gold did poorly over that period, so it shouldn't be too much of a surprise.

Again, I looked at DFA, just for my own curiosity, and it was up 19.71% over the same period. Now, that's a gross of the advisor fee for DFA, like if our client holds that, they're paying us some percentage based on their assets. I said the Wealthsimple numbers and the Rational Reminder model portfolio numbers, just net of fund fees. Although in the case of Wealthsimple net of their 0.5%, the dimensional numbers I said are not net of the advice fee.

Cameron Passmore: Exactly, exactly.

Ben Felix: But interesting numbers regardless.

Cameron Passmore: Agree.

Ben Felix: I thought that was neat. And hopefully that answers the questions of some of the people wondering about why their Wealthsimple portfolio has been flat.

Cameron Passmore: All right, so let's move on to the main topic. This comes from a client request actually, and it comes up a lot in discussion on inflation lately. With that, let's talk inflation.

Ben Felix: Let's do it. I called this topic, the ultimate inflation edge. Maybe that's a bit of a clickbait title, I don't know, but I am going to try and talk about what the ultimate inflation hedge might look like. Hopefully, by the end, it doesn't feel like clickbait. Now, take a big step back, I think, and talk about what inflation is. Maybe that's obvious to most people, but maybe it's not to some people, so we'll talk about it anyway. Inflation is when the prices of goods and services increase over time, meaning that you can buy less stuff with dollars that you've saved, pretty simple.

Now, since last March, central banks and governments have been trying really hard, like all the stuff that you hear about central banks and governments doing, it's not for the sole purpose of getting inflation to increase. Although you could actually maybe say that because deflation is what everybody worries about. If you get into a deflationary environment, it can be very difficult to get out of that. All of these monetary and fiscal actions that we've been seeing are largely to keep inflation up, and we've seen that actually.

We've seen that with central bank saying that they'll let inflation rise more than they normally would. The Fed said this because that's a sign that things are working and they don't want things to go in the other direction. Now, sometimes people say that this is somehow nefarious, that central banks and governments are trying to reduce their real inflation, adjust a debt load, or something like that by inflating their debt. I don't know. I don't really think that's necessarily what's going on there. I think inflation just a sign that economic activity is going in the right way direction, so it's a good sign.

Like I mentioned before, we don't want to get into a deflationary situation. Now, as much as positive inflation is a good thing, high inflation or excessive inflation or high unexpected inflation, any of those things are bad for the economy and for investors. If you think about it, within an inflationary environment, investment returns, nominal investment returns have to be higher if inflation is high for you to have a real inflation adjusted risk premium, fairly straightforward. I think one of the best or most interesting examples to look at is the 17-year-period from 1966 to 1982.

This is one of the worst times in US stock market history to retire. The S&P 500 returned 6.8% annualized before inflation for the full period. So, you look at that and say, well, how can this period be a bad period to retire.

Cameron Passmore: Exactly. Right.

Ben Felix: But if you're funding consumption over that period, which everybody is, everybody's got to fund their consumption, that 30 year period ended up being a period where you had, in inflation adjusted terms, zero, flat stock returns. So, you earned a 0% real return over that full period. That period starting, I think it was 1968, so within that period, was the worst 30 year period to retire in US history. When Bill Bengan, who was a guest on this podcast and explained exactly how he came up with the 4% rule. But in that analysis that he did, it was the 30-year period starting in 1968 that broke the 4% rule, that defined the 4% rule.

Again, though, it was not because of poor nominal stock market returns, which is what people tend to worry about the most. It was because of high inflation. Now, like I mentioned at the top of this segment, some inflation, some low, but positive inflation is something that central banks will want to have, and that's just part of the modern monetary system that we've been using for quite a while now. The Bank of Canada on their websites says, this is a quote, "We target inflation because a low stable rate of inflation is good for the economy. When people in businesses feel confident that they know what the rate of inflation will be, they can make long range financial plans that leads to an economy that functions better."

Cameron Passmore: Makes sense.

Ben Felix: Right. That's the same position that most central banks around the world have right now, using an inflation target. In Canada. The Bank of Canada's target is to keep inflation close to 2%, which has been fairly successful. Since 1900, and over that full period, we were not doing inflation targeting. That's a relatively recent development. If we go back to 1900 for Canada and the US, the numbers have been the same. Inflation for the full period, 1900 to 2020 has been about 3% per year. So, higher than the current target, but not that much higher.

One of the things that I think, I don't know if people realize or not, but it's not necessarily intuitive. When you buy a stock or a bond, current inflation expectations are built into the price that you pay. The discount rate on stocks and bonds includes inflation expectations, expected inflation.

Cameron Passmore: It has to.

Ben Felix: Right.

Cameron Passmore: Market participants will price that into their models.

Ben Felix: Exactly, because people care about real wealth, not nominal wealth. I think the easiest way to isolate observe what the markets inflation expectations are is using inflation protection government bonds. Because in that case, there's not a whole lot of credit risk. The security should be overall pretty similar if we're talking about government bonds, except in one case, if it's an inflation protected bond, it shouldn't have those inflation expectations priced in, because the bond will, in Canada and in the US, it'll adjust its principle for inflation.

Therefore, you don't need to have that priced into the current yield. If we look to observe the market's inflation expectation, you can compare the yield on an inflation protected and an unprotected or a nominal bond, and that gives you something called the breakeven inflation rate. What that effectively is, is the market's best guess at future inflation over the horizon of the bond, plus, and this part's important, plus a risk premium to compensate for the uncertainty about future inflation, because in the nominal bond, you don't just have inflation expectations, you have inflation in the discount rate, you have inflation expectations and uncertainty, like additional risk premium on top of the inflation expectation for uncertainty about future expected inflation.

Whereas you don't have that placed in a protected bond because it'll just.

Cameron Passmore: It's protected.

Ben Felix: It's protected. If we take, and I used US numbers because it's easy to pull charts from the St. Louis Fed website, so if you take the five-year breakeven rate on US treasury securities, it's currently 2.44%. That's the US market's pricing in 2.44% inflation plus or minus there's some adjustments for risk premiums and whatnot in there. Pretty cool. Pretty interesting. One big downside though, is that, as much as that's the market's current inflation expectation, it actually doesn't tell us anything about future realized inflation. We did a bunch of analysis internally over the last couple of weeks, trying to just examine this like, what is the best way for financial planning assumptions? What's the best way to model future inflation?

It turns out that, even though it seems intuitive that the breakeven rate would be one of the best predictors of inflation, it has very little relationship with future realized inflation.

Cameron Passmore: Really?

Ben Felix: Yeah. I thought that was pretty interesting, too. As much as it is what the market's expecting, the market's not very good at predicting the future, which I guess it shouldn't be a surprise to anybody listening. Another foundational piece of information to talk about inflation and how it relates to portfolios is that, expected inflation is not an issue for investors or for the economy, because market participants, like we've been talking about, build inflation expectations into asset prices, also into wage negotiations, into other financial contracts. So, expected inflation is there. It's built into prices, it's built into, and therefore it's not disruptive because everybody's planning for it.

Unexpected inflation is the bigger concern because when inflation ends up being a lot higher than anticipated by market participants, then there can be big problems. The main issue there is that unexpected high inflation benefits borrowers at the expense of lenders. If there's a lot of uncertainty about future inflation, lenders are going to demand a higher uncertainty premium on loans, which increases the cost of borrowing, and that can potentially slow down economic activity. It's kind of interesting to look at the guts of why unexpected high inflation is a bad thing for the economy.

That explanation is the theoretical side of the other thing that I'm about to say here, which is that stock returns, during periods of high inflation, have been quite poor. If you take annual stock and bond returns from 1900 through 2020 for 21 countries in the DMS database and sort them into percentiles based on each country's contemporaneous inflation rate for that year, so you rank the stock returns by the associated inflation rate in the same year, you see, and we'll post a chart in the YouTube video for this, but you can see pretty clearly that when inflation is at its highest, stock returns take a pretty significant hit.

Now, bond returns, under high inflation, are a lot worse than stock returns. So, market volatility, stock market drops, bonds tend to be pretty good at helping to protect that downside, kind of like the long bonds in Wealthsimple portfolio that we talked about earlier. If, instead of a market decline, we have high inflation, all of a sudden, bonds are no longer protective. They're actually riskier on the downside in a high inflation environment than stocks, at least in the historical data.

Cameron Passmore: Because you're the lender.

Ben Felix: Right. Exactly. This point that stocks performed poorly in a high inflation environment and bonds perform even a worse raises obvious questions about, what do you do? What do you do about inflation? Which is some of what we're going to talk about. Now, it is important though that while stocks don't act as a hedge in the short run because they tend to do poorly historically when inflation is high, over long periods of time, stock returns have outpaced inflation by a pretty wide margin.

Cameron Passmore: Just not during periods of high inflation.

Ben Felix: It's this distinction between an inflation hedge, which you'd expect to positively correlate with inflation and a positive risk premium, which you don't necessarily know when it's going to show up, but over a long enough period of time, it should deliver. So, stocks have a positive expected real return in the long run. That number's been 5.2%. That's real stock returns going back to 1900 for global stocks, plus 5.2%, but they're not going to protect you. Stocks are not going to protect you in an acute inflationary episode.

Cameron Passmore: Because you have two things going on, right? With inflation of higher revenues, which could lead to higher profitability. However, the discount rate that market participants are using is probably going to be increased and therefore a decrease in the price. Those are the two competing forces going on here in very simple terms.

Ben Felix: Yeah. I mean, I don't know. The cashflow piece is interesting too. I don't know. Because if high inflation stalls economic activity, that could affect the cashflow side too. I'm sure there's lots of ...

Cameron Passmore: Demand could go down. It's not maybe oversimplifying, but those are things that are going on at that time.

Ben Felix: Yeah. There are tons of different mechanisms that could explain it. There's probably a whole bunch of literature on what's going on, but I don't know if anybody actually has the answer, but your explanation as one component of it, definitely makes sense. Okay. So, we're in this situation where right now people are worried about inflation and we've talked about that period in 1966 to 1982, where we had 0% real stock returns for the full period of retiree at that period, as we've talked about, would have done poorly. I mean, that's what broke the 4% rule.

It's an obvious question for investors to ask, what should they be doing? What should they be thinking about if we're in a situation where we may have higher than expected inflation going forward? Of course, people are worried about this because of the government and central bank actions that we talked about at the top of the segment. I think an inflation hedge, a true inflation hedge has to have a handful of properties. I got this within the CFA Institute, like member's website, there's tons of really good material, and there was a talk from a guy who manages real asset portfolios.

He was talking about inflation hedges and how real assets can be used as inflation hedges, but my favorite part of the talk was when he defined, in his opinion, what an inflation hedge is. He said, "Ideally, an inflation hedge will correlate positively with inflation, including responding to unexpected inflation. It won't be too volatile and it will have a positive, real expected return." Now, the problem is that asset does not exist.

I read something from Ken French, he was talking about commodities when he wrote, but he said basically what I just said, that, that asset doesn't exist, because of who would be on the other side of that trade? Who wants to take the other side of that trade? So, of course, it can't exist, was his point. But there are some things that cover some of those criteria, just not all of them at the same time. Inflation protected bonds, which we mentioned briefly earlier are one of those things. From the perspective of correlating positively with inflation, well, now, that's not even true though, and I'll explain why that's not even true in a second.

A government inflation protected bond responds to changes in inflation. In the States, that's TIPS. In Canada, we have real return bonds. They adjust their principal to inflation every six months. That's what it is for TIPS. I think it's the same for real return bonds. If we have high unexpected inflation, the principal of the bond increase by that amount when the next reset happens. That's good. I'll talk about the shrinks in a second though. Now, like we've mentioned earlier, nominal bond yield, so non inflation adjusted yields have expected and inflation uncertainty priced in.

With increasing inflation uncertainty, real nominal bond yield will be increasing and increasingly higher than real inflation protected bond yields, all sequel. So, higher inflation uncertainty, the yield on a nominal bond will be relatively high compared to a real return bond. Now, the other big issue with inflation protected bonds, and this is the real stumbling block here, is that they're only an obvious hedge against unexpected inflation if the bond matches your investment horizon. If you say you have $100,000 expense in 20 years, you can buy an inflation protected bond maturing in 20 years.

If you do that, you're guaranteed to maintain your purchasing power, plus the real yield on the bond at the end of the 20 year period, so great. Perfectly hedges that one lump sum expense that you have. But the real problem here, why it's not necessarily a hedge, is that there's still a lot of uncertainty about the short term real return on a long-term inflation protective bond. Just like any other long bond, there can be a lot of meaningful short-term price volatility that overwhelms changes in inflation.

Even if the principal's adjusting for changes in inflation, unexpected changes in inflation, once they're realized, there are a lot of other things that can be the real return on that long-term bond, so therefore it's not a hedge against inflation. Because the principal adjustments to inflation changes can be completely overwhelmed by the duration of the bond, if interest rates change or the environment changes in a way that affects bond prices, return bonds are going to be sensitive to those changes. You could use short dated inflation protected bonds to get around the duration issue, the bond price volatility issue, but they introduce a whole new set of problems.

At current levels of expected inflation, the real return bonds have lower real yields than short dated nominal bonds, which already have low yields. I looked on Friday, and short data Canadian real return bonds have negative real yields right now. This means that, at the current level of expected inflation, you expect to lose purchasing power by holding short data real return bonds. Now, if there's unexpectedly high inflation, it could work out to be okay, but again, then we're betting on inflation being higher than the market currently expect.

One of the other assets that is probably the most counter-intuitive when it comes to dealing with inflation is short-term nominal, not inflation protected bonds, fixed income like bills, and cash. When I say cash, people would think that's the worst thing to hold during a period of high inflation. But I think that's only true for dollar bills. If you've got dollar bills sitting under your mattress, yes, that's going to lose all of its purchasing power or it's going to lose to inflation, whenever inflation goes up, the value of the currency will decline, but short-term debt and cash earn interest when they're sitting there.

Cash like electronic cash, I guess, a high interest savings account, not cash under your mattress, not currency. If central banks raise rates to combat inflation, which is something that has historically happened in many cases, not all, interest rates on short term debt will also increase. If rising it's hurt the price of longer maturity bonds badly, which is one of the reasons we see long bonds getting smoked in high inflation, but short maturity fixed income, like one month T-bills or hydro savings cash, like I mentioned is relatively unaffected in price. But as soon as the yield increase, they benefit from higher yields.

If you're rolling over short maturity debt, you're not really going to take a price hit, and you're going to benefit from higher yields as soon as they show up, so I'll take it back to that 1966 to '82 period, where inflation was really rough on stock returns. Over the same period, one month, nominal US Treasury bills beat inflation by a narrow margin, but they still beat it, but the important piece there is that they maintain their purchasing power over the full period while not being very volatile at all, which is back to the criteria for an inflation hedge. I don't know if they really responded to inflation. I guess they responded to rates which responded to inflation, but they were not volatile and they maintain the purchasing power.

So, not bad. One of the challenges is that it's not a necessity that rates are going to rise if inflation picks up. There are other things that governments and central banks can do to try and fight inflation that wouldn't necessarily involve raising the short rate. If that happened, then the strategy wouldn't work out so well. That being said, though, over very long periods of time, bills, short-term government debt have been pretty good at keeping pace with inflation. If you look at Canada, the US, and most other countries, a few, they haven't, but most countries bills have kept pace with inflation going back to 1900.

Probably not a perfect hedge, just like everything we've talked about so far, but to maintain purchasing power and limit volatility, I don't know, I think short-term debt cash is not nearly as bad as people probably think anyway. The next one that I looked at is gold, which is a fascinating one because it has this reputation as an inflation hedge, including in the Wealthsimple FAQ about why they had a goal to their portfolios is referred to as an inflation hedge historically, but it's not. It has not been historically good inflation hedge. In the 2013 paper, The Golden Dilemma, Claude Erb and Campbell Harvey showed that gold might be an effective inflation hedge if the investment horizon is measured in centuries.

But over more practical investment horizons that humans are planning for, gold is an unreliable inflation hedge at best. It's real price swings around pretty wildly in the short-term. The short term being less than hundreds of years. The other thing they looked at in that paper that was really interesting, is they looked at the relationship between unexpected changes in inflation and gold prices, so they found no relationship between gold prices and unexpected inflation.

Cameron Passmore: That is interesting.

Ben Felix: Yeah. Right? It is. It's not a hedge. Maybe it maintains its real purchasing power over very long periods of time, but it doesn't respond to changes in inflation, at least not in the historical data.

Cameron Passmore: But that doesn't line up with the stories.

Ben Felix: Yeah. Stories. Follow the stories, or do you follow the data? I don't know.

Cameron Passmore: That could be our new tagline.

Ben Felix: Gold's been a poor inflation hedge against, both unexpected unexpected inflation in the short run, and in the long run, maybe, maybe, but I'm not convinced. The other big problem that I have with gold is the uncertainty about what its expected return is. One of the beliefs, and this stems from the idea that gold has maintained its purchasing power over very long periods of time, one of the beliefs is that there's this golden constant, where gold does maintain its purchasing power in the very, very long run. That could be true. It's a possibility. This is something that Erb and Harvey, the same authors of the previous paper, they actually looked at it in a separate paper called The Golden Constant, is a 2016 paper.

They estimated what the golden constant value should be if gold and maintain its purchasing power over the very long run. If gold is an inflation, it maintains purchasing power, over the very long run, what should its price be today? When they wrote this paper in 2016, when gold prices were quite a bit lower than they are today, they found that gold was well above it's golden constant value. In that paper, the other thing they looked at is, what have gold returns looked like for the 10 years following when gold has been above its golden constant value.

They found that real returns, 10-year real returns were below average in periods starting when the price was above its golden constant value. Again, gold price is today, five years after that paper, are quite a bit higher than they were then. If there is a golden constant, if gold does maintain its purchasing power over the very long run, we might expect, now this is not a prediction here, but based on the golden constant idea, we might expect gold prices to decline, to come back closer to their golden constant value.

Then, I guess the other problem is, as a long-term holding, if we take the golden constant perspective, do you really want an asset with zero real returns, zero real expected turns over the very long run? The other thing is the opportunity cost. Like I mentioned, the criteria that the CFA video had on, what do you want in an inflation hedge? One of the things was a positive real return. The reason you want a positive real return on an inflation hedge is because anything that doesn't have that is a significant opportunity cost relative to holding stocks.

Cameron Passmore: Exactly, yeah.

Ben Felix: With gold, we see the same type of issue. Like again, bills and bonds, you go back in the historical to 1900, and they have had, for the most part, positive real returns, bills lower, bonds a little higher, and stocks even higher. With gold, there's a lot more uncertainty around what that expected return actually is. Again, gold, I mean, for all the criteria in this case, I don't think gold really checks any of the boxes, which is funny because of its reputation as an inflation hedge. Another one that I don't think gets discussed that much is international stocks.

I talked about how domestic stocks have tended to perform poorly during periods of high inflation. If a country has high inflation, that country stock market tends to, to do poorly, but the same is not been true for international stocks. If one country has high inflation, a foreign country's stock market is not necessarily going to have poor performance in that time period, which is intuitive. Like if Canada has high inflation, Italy stock market's not going to be necessarily affected by Canada's high inflation. Diversifying internationally, not really a hedge, because international stocks are still risky assets, and then they're not going to respond to inflation, but there might be a way to deal with some of that potentially inflation-related domestic stock market decline.

There was a paper that I looked at that talked about this, is a 2014 paper in The Journal Portfolio Management, Inflation Hedging With International Equities by Maximillian Rodel, and he showed that international equities hedge against inflation levels and inflation changes more effectively than domestic equities, more effectively. It doesn't mean they're a perfect hedge. You still got the volatility. That's not news to anyone. International diversification is a good thing. I looked at that 1966 to '82 period that I've brought up a couple of times, over that period, Canada and UK stocks, which are the ones that I had easily accessible data for over that time period, they both had a positive real return over the full period.

So, US stocks from 1966 to '82, 0% real return. Canada and the UK were able to outpace US inflation over the same time period. If a UW retiree at that time had one third US, one third Canada, one third UK portfolio, they would have done a lot better than the US-only investor. The last piece that I'll touch on and the most exciting, most exciting for me anyway, is value stocks. We talked about diversifying within stocks internationally, not just only in domestic stocks, but the other one is value stocks. There's some, I would call it more casual research on the relationship between the value premium and inflation, like Larry Swedroe had a nice blog post on the Alpha Architect website where he ran some numbers that was interesting.

Not a lot, at least that I was able to find, of real academic literature on this relationship. I played with the numbers myself and was able to recreate what Larry found, which is that there seems to be a pretty obvious relationship between the US value premium and US inflation, where when inflation's been on the higher end, the value premium has been higher, and when inflation has been lower, the value premium has been lower. I thought that was pretty interesting. I tried running it for international and emerging markets and Canadian stocks, and I tried using Canadian inflation instead of US inflation to sort premiums.

The relationship kind of falls apart, but it's still ... The US sample is really hard to ignore. Again, going back to the anecdotal experience of that '66 to '82 period, over that period, US value stocks, so we're not even going international here, US value stocks delivered a real annualized return of 6.71%.

Cameron Passmore: Wow.

Ben Felix: Yeah. That's not the value premium, that's the value index. That's not high minus low. It's not value minus growth. That's a value index, the former French value index. Then we'll put a chart, the chart that I mentioned, where I sorted value premium by inflation regimes, we can put that chart in the video, but you see, it's this perfect monotonic relationship, which is like, you look at that and it seems like there's got to be something going on there, but I don't think they're necessarily as I'm going to talk more about why. Changes in interest rates, we alluded to this earlier, too, but changes in interest rates are often accompanied by or response to changes in expected inflation.

There's a 2021 paper hot off the press in The Journal of Portfolio Management, titled, Value and Interest Rates: Are Rates to Blame for Values Torments? I guess there was an academic paper, but it doesn't validate the observation though. I guess there's no academic papers agreeing that there's a relationship between the value premium and inflation. In this paper, they look at the, how could this theoretically be true? If we see this pattern where value does better than growth when inflation is high, how could that be true theoretically?

Now, we know the theoretical value of a stock is the sum of its expected future cashflows discounted to their present day by a discount rate. The discount rate is the sum of the real risk-free rate, expected inflation and a risk premium. That's basic financial theory. Since inflation expectations and the risk-free rate are components of the discount rate, when they arise, asset prices fall, all else equal. Again, pretty basic theory there. Now, the intuitive theory explaining the potential relationship between value and inflation is that gross stocks have expected cashflows further in the future than value stocks do.

So, they have a higher duration. I'd mentioned duration very briefly earlier. It comes from fixed income. So, they borrowed this duration concept from fixed income. It measures a bond portfolio's sensitivity to changes in interest rates. How much price variability do you expect to have if interest rates change for your bond portfolio? This theory here is applying that same thinking to equities, because growth stocks have longer duration cashflows, longer dated cashflows. You'd expect the growth portfolio to have a higher duration than the value portfolio.

Cameron Passmore: Exactly.

Ben Felix: Right.

Cameron Passmore: That makes sense. I had not heard that before, but that makes sense.

Ben Felix: Yeah, it's interesting. And Larry talked about this in his blog post too. It's not a harebrained idea. It's been tossed around out there for a while. Now, under that theory, growth stock prices should rise more than value stock prices when the risk-free rate declines, assuming cashflows and risk premiums remained unchanged. That's duration. If growth stocks are longer duration assets, if the discount rate declines, their prices go up more than value stocks, which are shorter duration. The other thing that could affect that there is a fall in long-term yields relative to short-term yields, a flattening of the yield curve. That would benefit growth stocks more than value stocks.

It's a pretty compelling narrative. I like it a lot. One of the problems is it applying a concept related to fixed income to stock pricing has some pretty significant challenges. With bonds, cashflow expectations are fairly certain. With stocks, cashflows are uncertain. The other problem is that they probably change in response to the same economic conditions that result in interest rates changing. It's not obvious that the duration concept can just be transported over to stocks and give us the same kind of insights.

The authors of this paper find that, that despite what might look like in some samples, in the US sample, to be a relationship between the value premium and changes in bond yields or the slope of the yield curve, the economic significance of any relationship is small. They acknowledge it there. There does look like there could be a bit of a relationship, but it's small, and it's not robust in other samples, so they conclude that the performance of value is not easily assessed based on the interest rate environment.

And that factor timing strategies based on interest rate related signals are likely to perform poorly. I was really hoping that-

Cameron Passmore: I thought you're onto something.

Ben Felix: It's interesting. The narrative around this one, it's pretty strong. I thought it was interesting to see Larry write a post suggesting the same thing, that you might expect value stocks to be an inflation hedge, but this paper, it's from some of the guys at AQR, I think are associated with AQR. They found that there's not much of a relationship, at least not one that we should probably bet on. Okay, so to kind of try to tie all that together, I don't think that there is a perfect hedge against unexpected inflation. Doesn't exist, for the reason that Ken French said that, who would take the other side of that trade? Expected inflation is built into expected returns.

We typically expect to earn an inflation adjusted positive risk premium for owning stocks and bonds over long periods of time. Unexpected inflation can be disruptive to the economy and asset prices, and the sustainability of cashflows in retirement. So, it's definitely problematic. Inflation protected bonds are the only true hedge, but only if they perfectly match your investment horizon.

Cameron Passmore: Precisely.

Ben Felix: That's an interesting one. Long dated inflation protected bonds are probably too volatile to be a hedge in the short term against unexpected inflation, and short-term inflation protected bonds, which get around the duration issue, right now, they have negative real yields. So, short-term real bonds, probably not the answer either. Short term nominal fixed income and cash have historically responded quite well to inflation because rates, short rates have typically increased. Can we bet on that happening again in the same way in the future? I don't know.

So, I wouldn't call it a hedge. And do you really want a zero real return? Gold, like we talked about, I mean, it doesn't check any of the boxes, like I said earlier. It's not an inflation hedge in the short-run or the long-run. Maybe it is in the long-run, but if it is, it's a bad buy right now, if you believe that. International stocks again, too volatile to be considered a hedge, but they definitely provide diversification benefits, especially in the event that high domestic inflation happens, where domestic stocks will tend to do poorly.

There's some weak evidence that value stocks have tended to perform well relative to growth stocks during periods of increasing interest rates, which can be related to inflation, but it's not enough evidence to call it an inflation hedge by any means. But that being said, value stocks like international stocks offer a positive expected return independent of the domestic market. Well, I don't know if international is necessarily independent of the domestic market, but it's definitely another source of expected returns.

So, building a diversified portfolio, as usual, is probably a good thing, and I think that's probably the-

Cameron Passmore: That's the punchline.

Ben Felix: That's probably the best way to deal with expected and unexpected inflation. You think about the period where US stocks didn't have a positive real return over a 17 year period, and you got to wonder if that's ... What was that a period where inflation was responsible for the bad outcome, or was it just a period where stocks didn't have a positive real return? It could be either one, and it's not obvious to say that one thing is true over the other. But the more sources of expected return that you can have in a portfolio, I mean, small value stocks, value stocks, domestic equities, international equities, maybe fixed income, if it makes sense in the portfolio, and you decrease the chances of having all of your assets have a zero real return for an extended period of time. The ultimate inflation hedge I think is diversification, but that's not actually a hedge. It's just a way to deal with it.

Cameron Passmore: Got it. Under the cards, very good. Okay, so I picked a couple of cards here from Talking Cents, the Financial Education Initiative of the University of Chicago. Are you ready? You have not seen these before, so I'll go first. Do you prefer to save or spend? I used to enjoy spending a lot more than I do now. I don't know if it's the pandemic or just ... I honestly think it's all the discussions we've had around happiness and fulfillment, and back to Morgan Housel's enough versus more. I don't get the same enjoyment out of spending as I did before. I'm not anti-spending. I'm not a as ruthless as some of the fire type people, but I just don't. How about you?

Ben Felix: I was thinking about it while you were talking. I think I have a preference for saving, and that may not be necessarily a good thing. I also think I do a reasonably good job of thinking through financial decisions, where if spending might make sense, like the meal delivery service example that I always come back to, it might make sense from the perspective of the rest of my life, then I can rationalize it, but I think that's the key, is that for spending, I have to rationalize it. For saving, it just feels right as a default. Yeah, I would say I prefer doing.

Cameron Passmore: This next card is going to be easy for you. So, which is money more like, a tool or a treasure?

Ben Felix: Oh, it's a tool.

Cameron Passmore: Same.

Ben Felix: That's one of the key ... I think I said that in the ... When we talked about happiness, I think I said that, that you got to think about money as a tool, as opposed to the goal. Money is not the goal, it's something that facilitates other goals.

Cameron Passmore: Yeah. Okay. Onto bad advice of the week, and this one, we're not jumping on the dividend thing again. We've done this to death. This is more commentary on a magazine in our industry called Investment Executive. It was an article at March, 2021 issue, Investment Executive, entitled, Low Rates Add to a Lure of Dividend Stocks. Then the line below that, "Stable dividend yields are enticing when fixed income gets you next to nothing." Again, we're not going to bash dividends, we've done this enough, but it's more around the language, much like we talked about two weeks ago, I think it was, maybe it was a month ago.

The language that shows up in these articles. Here, this is an article in the magazine directed towards advisors. To get back to your comments earlier about, should you make decisions based on stories or evidence? There's no mention of evidence in here other than some evidence that showed that these managers did not outperform broad indices, but there's no digging into the power of the dividend as a source for higher expected returns, but just read some of these quotes, you see why retail consumers would love this if this is what's being fed to you and I as advisors. Here's some quotes, "A 4% dividend at a good blue chip stock that is traded relatively cheap to the market is a really good place to be right now."

This is a quote from one of the managers that was interviewed. "Valuations are cheap and yields are good. The pandemic create an environment in which banks can thrive, and you want to be well positioned to take advantage of the uncertainty we see coming. Now, we're going to use this crisis to enhance future shareholder value, and in a low interest rate environment, that's incredibly attractive. I think in today's low interest rate environment where traditional fixed income simply isn't generating the returns it has in the past, the stability of dividends becomes even more apparent." These are great stories, but it's nonsense.

Ben Felix: Yeah, that's unreal.

Cameron Passmore: Full of it, and these are big funds, big brand name funds.

Ben Felix: Of course, that's what they're going to say though, I guess. Right?

Cameron Passmore: But they're all stories predicting. Yeah, the return has been great lately, but because of easing of this, bank should have more of this, and the new rules for ... It's all predicting, like they're the only people that know these stories, and it comes back to the fact that, because it's got a good stable dividend, it can replace your need for fixed income? Come on.

Ben Felix: That's scary.

Cameron Passmore: Scary. Anyways, that's our bad advice of the week. Love to see pics. If you can share pics, tag us on Instagram, that'd be great. Love to see some summertime picks. Anything else, dad?

Ben Felix: No, like we mentioned in the introduction, we always appreciate the reviews, and we read all of them, and our understanding is that they help other people find the podcast. So, if you are enjoying the show, feel free to leave a review and we appreciate it, and maybe we'll read it in a future episode.

Cameron Passmore: Beautiful. All right. Thanks for listening.