When we last caught up with Professor Campbell Harvey of Duke University in May 2020, he was bullish amid the pandemic’s doom and gloom.
Harvey, whose negative yield curve model has had a perfect record of predicting recessions, said then that a vaccine — at the time a speculative prospect — would bring about a strong economic recovery and new market highs.
Now that that’s happened, he sees inflation returning, and not just temporarily, as a new paper he’s written with four other researchers shows.
In this Q&A, he discusses the impact on stocks and bonds, and tells which sectors will be hit hardest and which could be good places to hide. Harvey is a professor of finance at Duke’s Fuqua School of Business.
Howard Gold: An economic recovery looks much stronger than expected, and people are talking about inflation, which brings us to your paper. Do you expect to see inflation and do you expect it to be transitory or more long-lasting?
Campbell Harvey: It is obvious that the risk of inflation has increased. When I say “risk of inflation,” I mean, risk of inflation that’s above a level that we’re comfortable with. Inflation could go up by 3% and that could be good news if you start at minus one. You go from minus one to two, that’s just basically the economic engine revving up. When you go from two to above five, you start to get worried. We all know that inflation, once it gets to a high level, is painful to get it under control.
We really haven’t had inflation in 30 years, so most investors wonder why the Fed thinks this is such a big deal, because they don’t remember what happened in the early 1980s. It’s hard to imagine 20% interest rates. It’s hard to even think about that given the rates are so low today, but we’ve been through that and it’s been a long time. Of course, there are certain countries that have had bouts of inflation, like Zimbabwe and Venezuela.
Gold: That’s hyperinflation, though.
Harvey: We’re not Venezuela. We don’t need to worry about that. Nevertheless, what are the risk factors here? Well, number one, you’ve got a massive increase in the Federal Reserve’s balance sheet. You might say, “Well, that happened also during the global financial crisis and we really didn’t see a surge in inflation.”
That might be true, but I wouldn’t be very comfortable basing major decisions on one observation. The second thing is that we ran, in 2020, a double-digit deficit and in the forecast from the Congressional Budget Office (CBO) is another double-digit deficit in 2021. That will be the first time that’s happened since World War II. You put those two things together and the risk has increased.
Gold: Do you think we’re going to see a bout of sustained inflation or are these just temporary bottlenecks?
Harvey: This is really important for investors to understand. Number one, what impacts asset prices is longer-term inflation surprises. If you expect [temporary price increases] to be reversed, they won’t necessarily have a large impact on asset prices. What we’re seeing today is actually, in my opinion, a combination of two things. We’re seeing some inflation that is purely transitory, some supply chain issues. Those issues are causing, for example, the price of lumber or other commodities to shoot up to extraordinary levels. Those levels are unlikely permanent, and there will be some retreat from those levels.
I also believe that there is some component of what we’re seeing today that is a readjustment of longer-term expectations. The cleanest way to see that is derivative markets as well as the breakeven inflation from the Treasury Inflation Protected Securities (TIPS). We’ve definitely seen an increase in those expectations throughout the year.
I don’t think that it’s unreasonable at all that inflation by the end of 2021 is in the high threes, or potentially even crosses the 4% threshold.
Gold: 4%? By the end of this year? As measured by the Consumer Price Index (CPI)?
Harvey: Yes. That is substantially different than the sweet spot of 2%. I believe we will be well over 3%, potentially in the 4% range.
Gold: On Thursday, the government reported that the CPI had risen 5% over the past 12 months ending in May. Is this, or something close to it, what we can expect to see for the rest of 2021?
Harvey: The numbers we are seeing are a combination of temporary and longer-term effects. Some of the price increases will be reversed. However, other drivers such as housing costs and wage hikes are longer term in nature. I reject the idea that we can discount the 13-year high in inflation because it is a result of “base rate” (starting at a low point) and temporary effects. I continue to believe that a 4% forecast is credible.
Gold: You said in the paper that 5% is the real danger. And when unexpected inflation is over 5% annualized, stocks and bonds do badly.
Harvey: When we start again from the moderate level and exceed that 5% threshold, historically my paper, using 95 years of data and eight different episodes within the U.S., historically, equities get hammered. We showed that they lose 7% [annualized] on an inflation-adjusted basis.
It’s obvious that if you’re invested in bonds, if inflation increases, then interest rates increase and the value of the bonds goes down. The longest-term bonds, the 30-year bonds, are very sensitive. They’re very risky right now, [because with] a 1% increase in the interest rate, you could lose 20% on the 30-year bond.
If you think about an average portfolio that is 60% equities, 40% fixed income, you get it from both sides in an inflation surge.
Gold: Almost all of the sectors that you looked at, except energy and maybe health care, did very badly.
Harvey: The worst possible sector to be in historically is consumer durables, which lose 15% on an annualized basis. The energy sector and the health-care sectors have really small negative returns, like -1%. A simple thing to do is say, “Well, let’s look at the stocks in my portfolio and, oh, well, I’m actually heavily weighted toward consumer durables. Maybe I want to change the allocation and perhaps include some health care, for example, which is pretty resilient historically.” Simple things like a rebalancing of the portfolio, and this might be via individual stocks or sector ETFs, and maybe you just want to rethink the sectors that you’re exposed to. It’s immediately applicable to any investor. It doesn’t matter if you are an individual or large institutional investor.
This is the time to look at your sector exposures and consider a rebalancing. You can do this rebalancing and the inflation surge might not occur. That doesn’t mean you made a mistake. Maybe if you kept your original allocation, you would have made 1% or 2% more, but that’s just the insurance cost. That’s a simple thing to do.
Gold: You found that small stocks tend not to do very well during inflation surges. Now, small stocks have done extremely well over the past year or so. Should people who’ve gotten into small stocks move to larger stocks as well, or value versus growth?
Harvey: Small stocks are vulnerable. Again, you might think about reweighting your ETF portfolio. “Quality,” which has various definitions, tends to do better in inflationary surges, [and] value holds its own. Again, that’s better than taking a -7% hit.
Gold: During an inflation surge, TIPS are intuitively the best option, but the Federal Reserve has been buying up tens of billions of dollars of TIPS in its bond buying program. Has that distorted the market and made it a less attractive inflation hedge?
Harvey: TIPS actually deliver the inflation hedge by construction. They are indexed to inflation. However, they’re very expensive: In the periods of non-inflation, you’re going to have a negative return given where we’re starting. I don’t give investment advice, so I need to be careful here, but let me just say that TIPS are an expensive way to hedge inflation, and there are other, more straightforward things like rebalancing your portfolio toward sectors that are more resilient in [the face] of inflation.
Gold: How about commodities? They are a little harder to buy for retail investors. And if you buy the S&P materials sector
that doesn’t really do the job, does it?
Harvey: When we look at commodities, we’re looking at commodity futures and that’s not something that is easily accessible for the retail investor. We also show that buying equities that are linked to commodities, so for example instead of buying oil futures, you could buy a petroleum company stock, it doesn’t nearly deliver the same sort of protection, but it’s not bad. There are ways for retail investors to access commodities through some ETFs, but it’s not as easy as doing a simple rotation of the stocks in your portfolio.
Gold: You said in your paper that the inflation protection attributed to gold comes from a single occurrence in 1979. How many thousands of years has gold been around and that’s all people are hanging their hat on?
Harvey: The problem with gold is that it’s volatile and inflation is not that volatile. Gold is an unreliable hedge for inflation surprises. In our paper we [looked] at unexpected inflation and gold’s hedging ability, and we saw it was largely driven by the 1979 observation. In this new paper, we look at gold’s performance in different inflation episodes. During these inflation surges, gold actually does OK, but it’s still highly influenced by this single observation from 1979, [although] it does provide some protection.
Gold: How about crypto and bitcoin?
Harvey: Theoretically, bitcoin’s
supply is decoupled from the economy or any money supply. It’s just a purely algorithmic role and the last fraction of a bitcoin is minted in 2140. You can make a theoretical case that given that there’s no direct link with money supply or monetary policy in any developed country, that this is a potential hedge.
There are two major drawbacks here. Number one, the history is limited. We have quality data from 2013. We don’t have an experience in the entire bitcoin history of an inflation surge, [so] there’s basically no track record. The second drawback is, I mentioned that gold was unreliable because it was volatile. Well, the cryptos are six times the volatility of gold.
Gold: Six times more volatile than gold?
Harvey: We’ve seen inflation increase recently, maybe unexpectedly, to [5% in the 12 months ending in May] and what’s happened to bitcoin? It drops 50%. That’s the sort of volatility that makes it highly likely that a crypto like bitcoin is not going to be a reliable inflation hedge. Bitcoin’s prices are basically driven by the risk on/risk off. We saw in March 2020, the stock market drops by 35%, bitcoin drops by 50%. Then the stock market goes to a record high, bitcoin goes to a record high. Again, it’s a speculative asset. To think, “Well, I’m going to load my portfolio up with crypto because it’s an inflation hedge,” that is a purely theoretical argument and ignores some basic stuff like the volatility.
Harvey: Fintech has made it a lot easier for individual investors to be active in the stock market. They can buy fractional shares. They can have an account with Schwab
or Robinhood, and basically these investors are not full-time. They rely upon information that sometimes is not that accurate on Reddit and places like that. We’ve seen the steady decline of the share of retail investors and the overall market activity. It declined to about 10% in 2019 and it’s basically 15% in 2020 and likely 20% in 2021.
[So,] if you think what’s happening to GameStop or AMC is just because of the retail investor, that’s incorrect; many institutions and hedge funds are active in this market, taking advantage of this volatility. Basically, we see [large] deviations from fundamental value. That creates opportunities for other investors to capitalize upon that. This is not without risk, but in my opinion, really what we’re seeing is at least in the short term, certain markets become less efficient.
Howard Gold is a MarketWatch columnist.