That old saw about history not repeating but rhyming echoes these days, but some of the rhymes are strained. The resemblance to past events, in many cases, is more superficial than real.
Take the appearance of gasoline lines in parts of the Southeast this past week, which conjured up visions of the 1970s oil embargoes. Only this time, it wasn’t the doing of OPEC, then led by Sheikh “Yamani or your life,” as William Safire memorably dubbed him. Other nefarious actors, reportedly a Russian gang, managed to hack Colonial Pipeline’s key fuel artery to the region. In actuality, there wasn’t any real gasoline shortage, but a panic of hoarding, a reflex similar to the run on toilet paper in the early days of the pandemic a year ago.
The more pertinent parallels to be drawn to the 1970s relate to the uptick in inflation, that decade’s main economic feature, with consumer prices rising 4.2% last month—the biggest jump since 2008—from their level a year earlier. That news at midweek sent bond yields up sharply and stocks sliding, in a reversal of their relationship. (See our cover story here.)
For investors, this could be the most important change in a generation because it leaves them few means of protecting themselves. Not surprisingly, some new ones are emerging. But unlike the innovations of past eras, these are accessible to average investors with an online stock brokerage account.
Since roughly the turn of the century, bonds have been the yin to stocks’ yang. This inverse correlation made bonds a near-perfect shock absorber, with their yields falling (and their prices rising) during stock declines.
Whether because of the prevailing disinflationary trend or the perceived “put” provided by central banks—which could be counted on to slash interest rates whenever stocks dropped—this inverse relationship has underscored investment portfolios for institutions and many individuals for years. It also has been the basis of balanced portfolios split 60% in equities and 40% in fixed income.
Yet this stock-bond symbiosis shows signs of weakening, as this past week’s concurrent losses in both markets indicate. Indeed, the action harkens back to the 1970s, when soaring inflation and interest rates laid stocks low, especially when oil prices quadrupled, starting in 1973, triggering the painful bear market of 1973-74. But few investors active now were around in those days, observes Michael Cuggino, manager of the Permanent Portfolio fund (ticker: PRPFX), established in 1982 to preserve its holders’ purchasing power.
Back in the 1970s, investors could avail themselves of alternatives to stocks and bonds, notably money-market funds, an innovation that offered high short-term rates while deposit rates at banks and thrift institutions were still regulated. Precious metals also provided a way to play inflationary trends, especially after Americans were permitted to own gold again at the end of 1974. Oil stocks were another big inflation play, with energy being what tech is now in terms of market weightings. Now, energy is the smallest industry group, further attesting to petroleum’s lessened status.
Bonds no longer provide a hedge, either, given that their yields are more likely to rise than fall. Part of that reflects the historic descent in interest rates since their peak over 15% in 1981, all the way down to a historic low of 0.50% for the benchmark 10-year Treasury note last summer. That probably marked the nadir, given that subzero interest rates so far have been ruled out by the Federal Reserve, unlike its counterparts in Europe and Japan.
The diminished protection afforded by bonds in the traditional 60/40 portfolio has been much discussed over the past year or so. One alternative, suggested last year by Bridgewater Associates, was to substitute gold and Treasury inflation-protected securities, or TIPS, as a better hedge for a new era of rising inflation and interest rates. Over the past 12 months, the
exchange-traded fund (GLD) returned 5.91%, hampered by a 4.05% negative return since the beginning of 2021, according to Morningstar. The
ETF (TIP) returned 6.46% in the past 12 months and 0.37% year to date.
Some relatively new inflation plays—the
Quadratic Interest Rate Volatility & Inflation Hedge
ETF (IVOL) and the Horizon Kinetics Inflation Beneficiaries ETF (INFL)—were discussed here about three months ago. Joining them this past week is the Simplify Interest Rate Hedge ETF (PFIX), the brainchild of Harley Bassman, perhaps best known as the inventor of the MOVE Index—the VIX for bonds—when he headed Merrill Lynch’s mortgage operations in the 1990s. (This week’s Funds column covers these funds, as well.)
Bassman, who pens the Convexity Maven blog, late last year warned about inflation. Using instruments previously available only to institutional investors, his new ETF aims to provide anyone with a regular stock account a hedge against a substantial rise in long-term bond yields.
The Simplify ETF consists of equal parts seven-year Treasuries and a seven-year option on an interest-rate swap that pays off if long-term yields rise above 4.25%. Bassman says these derivatives represent cheap insurance against a surge in long bond yields that would probably accompany inflation.
The resulting upward-sloping yield curve such a surge would produce probably would be welcomed by the Fed and other authorities for its salutary effects on the financial system—and especially pension funds needing higher returns. But other real-world investors would be vulnerable, Bassman continues. Surging interest rates would probably wreak havoc with commercial real estate, whose valuations are inflated by current low capitalization rates. Municipal bonds, which typically have high coupons of 4% or more and are callable in 10 years or less, also would be at risk. A sharp rise in yields would probably mean that the bonds won’t be called and therefore would extend to their final maturity of 30 years or more, resulting in a plunge in their prices.
Cuggino likens his Permanent Portfolio, a traditional open-end mutual fund, to a hedge fund with highly diversified holdings: gold and silver account for 25% of the total; Swiss franc assets, 10%; U.S. dollar assets, mainly high-grade shorter-term bonds, 35%; real estate and natural resources, and growth stocks, 15% each.
One other way to stay ahead of inflation is with income that outpaces prices. DoubleLine chief Jeffrey Gundlach picked floating-rate corporate loan funds as his favorite income investment for 2021. Closed-end loan funds that fit his pick were included in a screen published on barrons.com. They have seen price gains and even some payout increases, with yields over 6%.
Unlike the 1970s, when the Fed at least talked an anti-inflation policy, the central bank openly is encouraging an overshoot of its 2% inflation target to offset past shortfalls and produce what it calls maximum employment. The current price surge is transitory, Fed officials insist. But investors might want some insurance in case Jerome Powell & Co. miss their mark.
Read more Up And Down Wall Street:Here’s What Could Stop Inflation in Its Tracks
Corrections & Amplifications
The rise in the April consumer-price index was the largest since 2008. An earlier version of this column incorrectly said it was the largest in four decades.
Write to Randall W. Forsyth at email@example.com