Hedging Inflation

One downside of a strengthening economy is rising inflation. So it is no surprise that keeping up with inflation becomes a hot discussion topic during such periods. But here the news is also good for equity investors. The bottom row in the table above reports the CPI inflation rate during each of the 12 rising interest rate periods. The stock market outpaced inflation in 75 percent of these periods (8 of 12) and on average bested inflation by an impressive 7.6 percent annually, well above the long-term average of 6.5 percent. 

In contrast, bonds failed to outpace inflation in any of the 12 periods and, on average, underperformed inflation by a disastrous 9.8 percent. Ouch!

A Behavioral Point Of View

The evidence is compelling that rising rates are good for stocks and bad for bonds. So why is there a general sense of anxiety pervading discussions of recent Fed announcements and how stocks will perform as rates increase? As is so often the case, investor emotions and resulting cognitive errors underpin this misperception.

Here are a few cognitive errors contributing to this investor misunderstanding:

  • The Fed and what they will do with interest rates is an example of an availability cascade, when a topic is so prevalent in the media that it dominates our decision-making. The conventional wisdom, repeated over and over again, is that rising interest rates will hurt stock returns as the Fed “takes away the punch bowl”. However, the evidence provided shows just the opposite, because the improving economic environment is what triggers the rate increase in the first place. In other words, rising rates are the result and not the cause.

  • Another popular notion is that “all things being equal” rising rates make fixed income more attractive on a relative basis and therefore money should flow out of equity and into fixed income. This is an example of a heuristic where we over-simplify things, applying simple rules to complex problems.  As such, all things are not equal with rates that are historically low and changes that are likely to be gradual.

  • Most fixed income assets are hurt by rising interest rates and so it is not surprising that some people may think stocks will be hurt as well. This is a representativeness bias, based on the incorrect assumption that interest rate changes are the main drivers of stock returns as they are for bond returns.