Nudge at Neptune

By Michael Ashton

Okay, I get it. Your stockbroker is telling you not to worry about inflation: it’s really low, core inflation hasn’t been above 3% for two decades…and, anyway, the Fed is really trying to push it higher, he says, so if it goes up then that’s good too. Besides, some inflation isn’t necessarily bad for equities since many companies can raise end product prices faster than they have to adjust wages they pay their workers.[1] So why worry about something we haven’t seen in a while and isn’t necessarily that bad? Buy more FANG, baby!

Keep in mind that there is a very good chance that your stockbroker, if he or she is under 55 years old, has never seen an investing environment with inflation. Also keep in mind that the stories and scenes of wild excess on Wall Street don’t come from periods when equities are in a bear market. I’m just saying that there’s a reason to be at least mildly skeptical of your broker’s advice to own “100 minus your age” in stocks when you’re young, which morphs into advice to “owning more stocks since you’re likely to have a long retirement” when you get a bit older.

Many financial professionals are better-compensated, explicitly or implicitly, when stocks are going up. This means that even many of the honest ones, who have their clients’ best interests at heart, can’t help but enjoy it when the stock market rallies. Conversations with clients are easier when their accounts are going up in size every day and they feel flush. There’s a reason these folks didn’t go into selling life insurance. Selling life insurance is really hard – you have to talk every day to people and remind them that they’re going to die. I’d hate to be an insurance salesman.

And yet, I guess that’s sort of what I am.

Insurance is about managing risks. Frankly, investing should also be about managing risks – about keeping as much upside as you can, while maintaining an adequate margin of safety. Said another way, it’s about buying that insurance as cheaply as you can so that you don’t spend all of your money on insurance. That’s why diversification is such a powerful idea: owning 20 stocks, rather than 1 stock, gets you downside protection against idiosyncratic risks – essentially for free. Owning multiple asset classes is even more powerful, because the correlations between asset classes are generally lower than the correlations between stocks. Diversification works, and it’s free, so we do it.

So let’s talk about inflation protection. And to talk about inflation protection, I bring you…NASA.

How can we prevent an asteroid impact with Earth?

The key to preventing an impact is to find any potential threat as early as possible. With a couple of decades of warning, which would be possible for 100-meter-sized asteroids with a more capable detection network, several options are technically feasible for preventing an asteroid impact.

Deflecting an asteroid that is on an impact course with Earth requires changing the velocity of the object by less than an inch per second years in advance of the predicted impact.

Would it be possible to shoot down an asteroid that is about to impact Earth?

An asteroid on a trajectory to impact Earth could not be shot down in the last few minutes or even hours before impact.  No known weapon system could stop the mass because of the velocity at which it travels – an average of 12 miles per second.

NASA is also in the business of risk mitigation, and actually their problem is similar to the investor’s problem: find protection, as cheaply as possible, that allows us to retain most of the upside. We can absolutely protect astronauts in space from degradation of their DNA from cosmic rays, with enough shielding. The problem is that the more shielding you add, the harder it is to go very far, very fast, in space. So NASA wants to find the cheapest way to have an effective cosmic ray shield. And, in the ‘planetary defense’ role for NASA, they understand that deflecting an asteroid from hitting the Earth is much, much easier if we do it very early. A nudge when a space rock is out at the orbit of Neptune is all it takes. But wait too long, and there is no way to prevent the devastating impact.

Yes, inflation works the same way.

The impact of inflation on a normal portfolio consisting of stocks and bonds is devastating. Rising inflation hurts bonds because interest rates rise, and it hurts stocks because multiples fall. There is no hiding behind diversification in a ’60-40’ portfolio when inflation rises. Other investments/assets/hedges need to be put into the mix. And when inflation is low, and “high” inflation is far away, it is inexpensive to protect against that portfolio impactor. I have written before about how low commodities prices are compared with equity prices, and in January I also wrote a piece about why the expected return to commodities is actually rising even as commodities go sideways.

TIPS breakevens are also reasonable. While 10-year breakevens have risen from 1.70% to 2.10% over the last 9 months or so, that’s still below current median inflation, and below where core inflation will be in a few months as the one-offs subside. And it’s still comfortably below where 10-year breaks have traded in normal times for the last 15 years (see chart, source Bloomberg).

It is true that there are not a lot of good ways for smaller investors to simply go long inflation. But you can trade out your nominal Treasuries for inflation bonds, own commodities, and if you have access to UCITS that trade in London there is INFU, which tracks 10-year breakevens. NASA doesn’t have a lot of good options, either, for protecting against an asteroid impact. But there are many more plausible options, if you start early, than if you wait until inflation’s trajectory is inside the orbit of the moon.


[1] Your stockbroker conveniently forgets that P/E multiples contract as inflation rises past about 3%. Also, your stockbroker conveniently abandons the argument about how businesses can raise prices before raising wages, meaning that consumer inflation leads wage inflation, when he points to weak wage growth and says “there’s no wage-push inflation.” Actually, your stockbroker sounds like a bit of an ass.

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Gary

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