May 23, 2021

Stop Inflation Hyperventilation

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Bottom Line:


The current narrative that higher inflation rates will dash profit margins, depress valuation multiples, and eliminate investor returns does not pass historical scrutiny.  Over the last 95 years, the US economy has navigated periods of deflation and inflation while still providing double-digit annual returns for equity investors.  The low inflation levels of the last decade have been the exception, not the rule.  Since the US abandoned the gold standard in 1971, inflation has averaged 3.8% annually, while large stocks averaged 12.6% and small cap stocks averaged 15.3%.  Should Fed policy induce 2%+ inflation rates for an extended period of time, as intended, we will simply be reclaiming our long-term average inflation levels and… with any luck, our long-term average investor returns as well.


The Full Story:


Aside from the crypto crash, investors remained fixated this week on the existential threat of inflation.  Per the narrative, higher overall inflation will mean lower profit margins and lower valuation multiples.  The prospect of lower margins and lower multiples should alarm investors as those heady headwinds could limit, if not reverse, investor returns.  As studious investors, we take note of daily investor anxieties, but we never accept narratives at face value.  After donning our green eyeshades and digging deeply into the data sets, we have some encouraging information to share on the historical relationship between inflation and investment returns.



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The Gold Standard


After years of pernicious deflation during the Great Depression, FDR officially removed the gold standard in 1933.  By executive order, holders of gold and gold certificates had to convert them into US currency, backed by gold, at a fixed price of $20.67 an ounce.  Once the Federal Reserve became flush, they raised the conversion price to $35 an ounce, effectively increasing the money supply by 69%.  The dollar remained pegged to gold at $35 an ounce until markets forced Nixon to remove the peg in 1971 after LBJ’s guns and butter spending spree.  Other than the economic distortions caused by WWII, the US experienced very little inflation until the late 1960s.


The Fed Standard


The transition from gold to fiat led to a significant and prolonged adjustment period while the US central bank learned how to manage inflation and inflation expectations.  From 1971 to 1980, inflation in the US averaged 8.1% per year, with gold peaking in January of 1980 at over $850 an ounce.  To break inflation, Federal Reserve Chairman Paul Volker raised interest rates to 20% by March of 1980 and left them there for a year.  This created two painful recessions, but established the US central bank’s credibility as a powerful and determined inflation fighter.  The Fed effectively became the new gold standard, with inflation running 2.6% on average for the last 30 years.


The War on Deflation


The Federal Reserve and their overseas counterparts fear that the combination of globalization, digitization, and population deceleration trends will create a persistent and pernicious downforce on general price levels.  To offset these deflationary forces, central banks have resorted to unorthodox policies such as quantitative easing and negative interest rates.  Japan has deployed the most aggressive and inflationary policy mix and yet still suffers from a deflationary undertow.  The US Fed’s longer-term deflationary concerns more than offset their shorter-term, supply shortage induced inflationary concerns.  Hence, their message anchoring around current inflation as “transitory”.  Strategically, the Fed has opted not to fight the battle on current inflation in order to win the war on future deflation.  In our opinion, widening the macroscope lens supports their controversial stance.


Inflation and Investment Returns


I have provided this perspective to establish that inflation/deflation and their management responses have varied widely over the last 100 years.  Even still, investors have managed to compound money at double-digit rates over the entire time frame.  Furthermore, the annual rates of return often seem impervious.  Consider the data below:



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Clearly, markets can rise in any inflationary environment, refuting the assumption that inflation kills margins, multiples, and investor returns.  The highest average annual returns occurred when inflation ranged between 1 and 3%, but double-digit returns occurred all the way up to 5%+.  Surprisingly, in 1980, inflation averaged 12.4%, and yet large cap stocks advanced 33% while small cap stocks rose 40%.  Inflation may influence investor returns, but it certainly doesn’t determine them.


Now, to diffuse the emailers who will cite real (inflation-adjusted) returns as the proper measure, I agree mathematically but not in practice.  For individual investors, inflation amounts to changes in spending levels, not general price levels.  The real returns for investors equals nominal investment returns minus their own drawdown rate, a portion of which may offset rising inflation but not all.  At home, spending decisions determine overall inflation rates and therefore net, real returns.


Have a great Sunday!



David S. Waddell 
CEO, Chief Investment Strategist



Sources:, Ibbotson, St. Louis Fed, Standard and Poors, Russell


David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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