Investors are bracing for a year of rising interest rates as the U.S. Federal Reserve attempts to tame inflation. However, the outcomes would vary across asset classes based on the pace of the Fed’s actions, according to Wharton finance experts. The Federal Reserve has indicated at least three rate increases of 0.25% each in 2022 with the first of those set for March. Some bank economists have projected as many as five to seven such increases.
“In the U.S., headline inflation just hit 7%, a number that we haven’t seen since 1982,” said Wharton finance professor Joao Gomes during a Wharton Executive Education LinkedIn Live panel he moderated last week titled, “Investing in a High Inflation World.” (Watch the video below.) “Even after we excluded the historically volatile food and energy components, the so-called core inflation was still at 5.5%.”
Increasing interest rates is one of two ways by which the Fed will try to rein in inflation; the other is by reducing its net asset purchases beginning in March. The Federal Open Market Committee outlined those strategies in its statement last week. It also took the gloves off on its interest rate moves: “With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate,” it stated.
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“Three or four rate increases by the end of the year puts us at about 1% or 1.25% [from 0.25% now],” said Wharton finance professor Nikolai Roussanov during the event. “It all depends on how dramatically markets behave in response to that, and whether the Fed still has the stamina to keep going through with these hikes over the course of the year.” The recent turbulence in the markets indicates that investors are “trying to process” the likely impact of those rate increases, said Roussanov. Growth stocks have already taken a direct hit over concerns of rising interest rates.
Roussanov pointed out that the Fed’s actions on interest rates will be guided by its twin goals of price stability and full employment. He expected the Fed to take a pause “if we see a serious pullback in the market — not what we have seen over the last week, but something that’s truly forecasting an immediate, impending recession.” The Fed “will ultimately pause on the hikes as they would need to compromise between the inflation-fighting goal and the speed of economic recovery.”
The pace of the Fed’s rate increases is a crucial make-or-break factor. “Potentially, the Fed can reduce demand [to control inflation] by effectively taking some of the air out of the stock market by hiking rates rapidly,” said Roussanov. “But that will do damage on a lot of fronts,” he warned. For one, as stock prices contract, “all those 401(k)s aren’t going to look as good,” he noted.
How and Whom Inflation Hurts
Broadly, rising inflation hurts investors in two ways, Wharton finance professor Itamar Drechsler explained during the panel discussion. One is it reduces the value of nominal assets that are not adjusted for inflation, such as U.S. Treasury bonds or corporate bonds. “The returns on those assets will be very bad if inflation is unexpectedly high,” he said. The other effect plays out when the Fed raises interest rates to contain inflation, which reduces the prices of assets such as stocks and real estate, he added. “The concern that the Fed will have to raise interest rates a lot has a powerful effect on all asset valuations, namely, to make them go down.”
Roussanov said the Fed is especially sensitive to core inflation, “because that’s the component that is the most persistent.” Core inflation tracks prices of goods and services including shelter, household furnishings and operations, apparel, transportation, medical care and recreation. Core inflation gets worrisome if it is higher than the threshold of 4%, he added; the current rate of 5.5% represents the largest 12-month increase since February 1991.
In a recent research paper titled, “Getting to the Core: Inflation Risks Within and Across Asset Classes,” Roussanov and his coauthors decomposed inflation into core and non-core components to weigh their risks on different asset classes. “Conventional inflation hedges such as currencies and commodities only hedge against energy inflation risk but not the core,” they stated in the paper. “These hedging properties are reflected in the prices of inflation risks: Only core inflation carries a negative risk premium.”
Roussanov and Drechsler outlined how high inflation and rising interest rates affect different sectors and asset classes:
- Value stocks do better than growth stocks in inflationary periods. In the case of growth stocks like those of tech companies, a popular view is that higher interest rates push their profits and cash flows further out in the future. While evidence of this effect is mixed, value stocks are somewhat shielded from higher inflation as they tend to be more indebted, and inflation provides a relief from nominal liabilities that growth stocks might not experience.
- The same logic applies to bonds, where an increase in rates compounds over time. The value of longer-duration bonds (whose cash flows are further out in the future) decreases more than that of shorter-term bonds with near-term cash flows. Higher-risk corporate bonds are not hurt as much because reduced real value of nominal debt lowers their default risk.
- For corporate borrowers, longer-term rates are likely to increase more than those for shorter-term commercial and industrial funding.
- Commodities are seen as an inflation haven and outperform other asset classes when inflation is high, although their strong performance is largely driven by energy and food inflation.
- Gold is also typically seen as a safe haven, but while it “doesn’t perform too well” in times of high expected inflation, it rises in value “in times of surprise” – when inflation is higher than expected.
- Similarly, real estate is also seen as a haven against inflation. But real estate does badly in times of very high inflation because the higher interest rates that follow make housing mortgages less affordable for homebuyers, and construction companies have hard time finding the capital to operate profitably.
- Real estate investment trusts, or REITs, behave more like stocks and bonds and suffer when interest rates rise because their cash flows deteriorate in real terms — payments that tenants make to landlords don’t get adjusted in tandem with interest rate increases.
- Cryptocurrencies like bitcoin have been seen as replacing gold as an inflation haven. But bitcoin’s recent price performance doesn’t suggest that it offers much protection from inflation as it leaves investors with too much unrelated “basis” risk.
The Elephant in the Room
As the Fed shapes its inflation-fighting strategies, “the elephant in the room is investor expectations,” said Drechsler. “Many observers and policymakers believe that people’s expectations about future inflation are actually a driver of inflation, meaning that if people got used to inflation being, say, 2%, then that’s likely to keep it at 2%,” he explained. “But if a series of events happen that make inflation more likely in their mind to be 4% or 5%, then [some believe] that in and of itself drives inflation more towards 4% and 5%. If that happens, [high] inflation would last for a long time. And policymakers would have to raise the nominal interest rate even higher than that for a while. The combination of those two factors is likely to have a very big effect on the discount rates that go into the pricing of assets and to bring prices down a lot.”
The experience of the previous era of high inflation — between the mid-1960s and the early 1980s — offers lessons for policymakers, Drechsler said. In a recent research paper, Drechsler and his coauthors studied that so-called period of “Great Inflation” and found that a ceiling on deposit rates the Federal Reserve had imposed, called Regulation Q, “led to credit crunches, which reduced production, while also driving up aggregate demand, which pushed up inflation and further lowered the real return to saving, setting off an inflation spiral.”
The Great Inflation period seems to have left the markets overly sensitive to the potential aftermath of high inflation. “It’s a really important part of the consciousness that we have now — that high inflation comes with bad news,” said Gomes. The outcomes could turn out to be worse than warranted, he suggested. “Historically, what we’ve seen is that every time there’s news of high inflation, the markets get spooked very easily.”
The takeaway for many people from that time is that “it is very important to treat the disease early before it gets out of control,” said Drechsler. “Whenever there’s a concern that…inflation is going to run away from us, investors can get very nervous that [the Fed] will have to raise rates a lot.”
In the 1970s, GDP growth and inflation moved in opposite directions. “Every time inflation was going up, GDP growth was falling fast,” Drechsler said. “This is what people called ‘stagflation’ because …you had both low growth and higher inflation.”
Drechsler did not see the current situation leading to stagflation. In the 1970s, supply disruptions were “very much at the heart of inflation, but they were manmade,” he noted. The cap on deposit rates had led people to pull out their deposits, which in turn made credit scarce and costlier for firms to finance their production and operations. “Today also we have supply chain disruptions, but they are because of COVID and a shift in consumption from services to goods. If those supply disruptions decrease, this [phase] will not necessarily lead to stagflation – unless the supply [constraints] get really, really bad.”