Beware the Invisible Losses Inflation Foists on Investors

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Advisor Perspectives
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Inflation

When it comes to investment returns, most people, including those who work in financial markets, only consider nominal numbers. For example, they look at the price of the S&P 500 Index now, where it was a year ago and work out what the total return was including dividends in that period. They do the same calculation for bonds, substituting interest payments for dividends. By those measures, the S&P 500 returned about 14% and 10-year U.S. Treasury notes lost about 5%.

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But what investors should be looking at are real numbers, which take into account the effect of inflation. This is not an abstruse, academic distinction. Good investments are ones that should, at the very least, maintain your ability to buy the things you want and need to buy in the future. In periods of low inflation, there isn’t much difference between nominal and real returns in the short term. When inflation is high and rising, good nominal returns become more modest ones, modest returns turn into bad ones and bad returns turn into woeful ones. In the examples above, the real returns have been roughly 7.7% for the S&P 500 and minus 12.5% for 10-year Treasuries given that the consumer price index surged 7.5% in the period. The Russell 2000 Index of small cap stocks lost 16% in real terms and, measured in dollars, emerging markets some 20%.

And with central banks set to rein in inflation, albeit very reluctantly, more obvious nominal losses will be added to less visible real losses. That is what happens when the risk premiums demanded by investors in almost every asset class are miniscule – as is still the case even after the recent turbulence in markets. Government bonds are a decent proxy for extremely slim risk premiums. The overwhelming consensus in markets is that inflation will rapidly drop, capping the rise in short-term interest rates and bond yields and thus supporting all types of riskier assets.

Inflation

Central banks have said they are on the case. Some of them have even promised to push short rates up a bit to combat inflation. The rise in bond yields over the last six months has helped drive real yields — the yield offered by inflation-linked bonds before inflation is added in — higher. The yield on five-year Treasury Inflation-Protected Securities, for example, has jumped by a percentage point since mid-November. It is that rise in real yields that has unsettled other markets.

Read the full article here by Richard Cookson, Advisor Perspectives

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