The markets have not had a good year so far
Most major market indices have been negative year to date
(performance quoted as of 2/21/2022):
S&P 500 Index = -8.54%
LB Aggregate bond market index = -3.64%
Morningstar US Real Estate index = -12.07%
Bitcoin = -19.54%
There have been a few bright spots:
Gold = +3.60%
Silver = +2.84%
Energy (oil & gas) = +20.65%
Latin America = +12.07
As you can see by the list above, these ‘winners’ are very specific and represent what is working in this market – not necessarily what will or has worked over the long term. Trying to find shelter in this storm is extremely difficult. It seems any rebalancing is an exercise in choosing what investment is the least negative year to date as there are so few positively performing options.
Inflation-Protected Mutual Funds
These were great investments over the last year. Now? Not so much. Vanguard has two inflation-protected bond funds – a short term (VTIP = ETF/VTAPX = mutual fund) and an intermediate term fund (VIPSX = mutual fund only, no ETF available). Fidelity, T. Rowe Price and some other fund families also have inflation funds. These funds invest in Treasury Inflation-Protected Securities (TIPS) where the interest rate on the bond adjusts to match inflation every six months. TIPS are issued in 5, 10 and 30 yr. terms. The short-term TIPs fund has a duration (term) on average of 2.50 yrs. The Intermediate-term TIPS fund has a duration (term) of 7.50 yrs.
Performance for these funds is as follows:
2021
VTIP/VTAPX = 5.36%
VIPSX = 5.56%
2022
VTIP/VTAPX = -0.66%
VIPSX = -3.31%
While the 2022 performance is nothing shocking, it is much different than 2021 performance. Inflation was 1.40% in January 2021 and rose to 7% by December 2021. Inflation came in at 7.50% for January 2022. We saw a problem when inflation rose 0.90% in April 2021 – the largest increase in 39 years. This surge was unanticipated – economists had been predicting a modest 1.80% core inflation rate for 2021.
Conditions were ideal for inflation hedges, such as these two Vanguard funds, not only because prices surged but also because it happened so suddenly. These investments should defend against such surprises. A hedge that doesn’t shield against abrupt shocks is a failed hedge.
There have been four very popular but failed hedges in this market:
Gold – The traditional inflation hedge with 5000 years of price history. Unfortunately, the performance of Gold has remained ‘lackluster’ (pun intended!). No one looking at the gold price chart would be able to tell there was inflation.
Treasury-Inflation Protected Securities – Along with gold, TIPS are the most logical inflation hedge. After all, they were created by the U.S. government for exactly that purpose. As with gold, TIPS have gone nowhere. From May 12 until now, they have gained barely more than 1%. So far this year their performance has been worse yet, with TIPS chalking up losses.
Cryptocurrencies – Cryptocurrencies are commonly regarded as electronic inflation hedges. That makes sense. Historically, gold has appreciated when fiat currencies have stumbled. So, why would the modern equivalents of gold behave differently? Unlike gold, cryptocurrencies haven’t broken even in 2021. They have lost money, badly. (Bitcoin’s main rivals of Ethereum and Binance Coin have performed somewhat better, but they have also been in the red since mid-May.)
Energy – Energy long ago lost its investment allure. Not only has oil badly trailed other assets since its 1980 peak, it also hasn’t protected well against stock-market declines. Crude oil fell during the 2000-02 technology-stock downturn, lost two-thirds of its value through the 2008 global financial crisis, and briefly turned negative amidst the pandemic. Recently, oil prices have surged, making energy the sole winner among the four potential inflation hedges.
The problem doesn’t lie with these assets. Cryptocurrencies may prove to be illusory, and while oil prices advanced during this inflationary bout, they might well sink during the next one should industrial demand be slack.
Gold’s inflation-fighting powers have been amply demonstrated over many centuries. And TIPS were explicitly designed to combat rising inflation.
The reason for the uninspiring performance of the inflation hedges lies elsewhere, outside the investments themselves. One possible explanation is that current inflation is only temporary. When the global supply chain becomes unstuck, inflation should diminish.
Another interpretation is that although inflation’s arrival caught market forecasters unawares, it did not surprise institutional investors. They did not know when inflation would surface, any more than did the forecasters, but knew that sooner or later bad news would arrive. As a result, they had already bid up the prices of inflation hedges so when inflation did appear, gold and TIPS failed to react because it had already been priced into their values.
The bottom line?
A negative return of 3.31% year to date shouldn’t be a cause for panic. During the last year, we recommended clients move money into short and intermediate-term TIPS funds to earn 5%+ in low-risk government-backed TIPS – conservative investments paying a decent return in a world where cash is 0.50% or less.
Now that these investments are posting negative returns, clients may want to reconsider these funds. If you had invested funds that you did not want any negative returns (i.e., home down payment, upcoming remodeling project, etc.), you may want to reconsider these investments and move into cash. Cash will provide negligible gains, but promises no negative returns.
Lastly….what about iBonds?
Given inflation at 7%+, investors have flocked to iBonds. iBonds are savings bonds that earn interest based on combining a fixed rate and the current inflation rate. The fixed-rate stays the same for the life of the bond. The inflation rate is adjusted 2x/year – every November and April. For bonds issued in November 2021, the combined rate is 7.12%. This rate is variable NOT a fixed rate.
iBonds earn interest for 30 yrs. unless you cash them in. The interest is free from Federal income tax, but subject to State tax. You can only buy $10,000 in iBonds (per SSN) electronically each year. If you buy a paper bond, the limit is $5k/year. You can cash these bonds in after one year. But if you cash them before 5 years, you lose the previous 3 months of interest. The interest and principal are paid to you when you cash in the bond.
Currently, the fixed rate on iBonds is 0%. What makes them attractive is inflation at 7.50%. But while the inflation rate is variable, the fixed rate on these bonds is set at 0%. This means when inflation moderates and resets every six months, the rate will decline over time. Be aware you are not buying a 7.12% fixed rate bond.