BND - With Inflation Still High These ETFs Will Likely Disappoint This Year

2023-08-30 11:01:45 ET

Summary

• Inflation above 2% has a negative impact on stock prices; the Vanguard Total Stock Market ETF has averaged poor performance during such years.
• Various sub-sectors of the stock market and sectors of the bond market are affected differently by high inflation.
• My data shows that energy, utilities, and gold stocks tend to perform well during periods of high inflation, while value category funds outperform growth category funds.
• Bond ETFs don't perform well during periods when inflation ends a year above 2%; a TIPs fund may outperform other categories.

Investors seeking the best yearly returns should take into consideration inflation data for clues as to what to possibly expect from their stock ETF investments. according to my Dec. 2021 article here on Seeking Alpha. In it, I examined the overall effect of end-of-year inflation above the Fed's 2% target on that year's ETF prices. The results showed that between 2005 and 2021, there was a significant negative relationship between overall stock prices and the Consumer Price Index ((CPI)), a widely accepted measure of inflation. When inflation exceeded a relatively benign level of 2%, stock prices on average, as measured by the Vanguard Total Stock Market Index ( VTI ), tended to perform poorly; when inflation was below that level, VTI performance, on average, tended to do considerably better.

VTI represents an important indicator of the performance of all sectors of the US stock market Since inflation appeared to be barreling higher at the time, I suggested that investors who want to potentially avoid possibly poor stock fund returns in 2022 might want to trim down their stock fund holdings. As it turned out, by one year later, it ended the full year at 8%, the worst inflation since 1982; over the same period, VTI dropped 19.5% This was a perfect example of the negative relationship. But remember that since the relationship is not perfect, it would not hold true every single year, but only on average, as a general tendency.

Of course, VTI represents an important potential indicator of the performance of all sectors of the US stock market as a whole. However, I wanted to if see if various sub-sectors of the stock market were more affected by high inflation than others. In addition, I wanted to see if various sectors of the bond market were equally affected by high inflation. To that end, I conducted a second study in Apr. 2022; you can review those results here .

Method

Data on the average one-year returns of 11 of the 12 funds tested in the Apr. 2022 article were computed and compared to the 18 end-of-year inflation data between 2005 and 2022. (Vanguard Total Bond ETF ( BND ) was not available long enough to include in this second study. Instead, iShares Core US Aggregate Bond ETF ( AGG ), a very similar ETF measuring the entire US bond market, was included.) In addition, several other ETFs were included in the analysis: Vanguard Small Cap ETF ( VB ), Vanguard Mid Cap ETF ( VO ), and iShares TIPS Bond ETF ( TIP ) since Vanguard's inflation ETF ( VTIP ) also wasn't available for long enough to include in the study.

Results

The following tables show the results:

Table 1. Average Stock ETF Annual Return When Inflation Above 2%

Table 2. Average Bond ETF Annual Return When Inflation Above 2%

When we examine average one-year returns, we can see quite clearly how inflation above 2% was dragging down average returns for most types of ETFs.

Out of the 11 stock funds included, which covered a wide assortment of US stock fund categories, only three showed one-year returns of greater than 5 percentage points.

Out of the four bond ETFs included, the highest return was 2.88% for the inflation protected fund. A TIPs fund may outperform other categories.

When we look at the average one-year returns after greater than 2% end-of- year average inflation, we can see that, based on past history, betting on most stock or bond funds at this level of inflation usually falls short of the same funds returns over all years. For example, the investor who held VTI on a buy- and-hold basis for all the years between 2005 and 2022 would have received a total return of 8.77% annualized, considerably more than the average 3.00% return for years of higher inflation. The effect was not as clearcut for the bond market; all four funds included showed average yearly returns below 3%, a low yearly return. Clearly, inflation above the Fed's 2% goal did have a damaging effect on most stock and bond ETFs, chosen to represent different categories of funds.

Which stocks funds were the exceptions? You can see that those investing solely in energy, utilities, and gold were able to buck the negative effects of inflation. And value category funds, while not providing a high return, did 2% better than large growth category funds on average per year.

Implications

The results of this final study confirmed the fact investors who hope to get the best end-of year returns when yearly inflation exceeds 2% should consider pulling back from most of their stock funds, which, by the way, would apply to mutual funds as well.

Would they have done any better by switching to bond ETFs? Not really. Most categories of bond ETF returns included did not exceed the 3% average one-year 3% return generated by VTI.

Of course, no one can guarantee that this is how funds and their representative categories will behave in the future. The figures reported in Tables 1 and 2 are only averages . In some years of high CPI inflation, such as 2021 when inflation was 4.7%, VTI returned 25.7%. But 18 years of inflation data and their corresponding fund category performance would seem to be quite helpful in determining which type of investments the investor should likely focus on in any expected upcoming years of high inflation.

In that regard, 2023 is still almost certain to end the year as a high inflation year. If we take the average of each of the 7 CPI inflation reports issued this year (Jan. through July), we come up with an average of 4.64% per month (see Current US Inflation Rates: 2000-2023 ) In order to get average inflation down to 2% by the time the Dec. report comes out, we would actually need for there to be not only disinflation (that is, inflation that drops down but remains above zero) but also deflation (that is inflation that drops below zero), during the remaining 5 months. Since such an average rate of inflation over the entire 12 months is nearly impossible to happen given that more than half the year is over, investors seeking better than possible low single digit returns on most of their funds should tread carefully regarding their stock funds for the remainder of the year. Perhaps next year will be a different story.

How can one know in advance how inflation will end any given year? Monitor the monthly inflation reports using the above link. Also follow Fed announcements and actions, as well as trust what you see regarding whether most prices are going up creating new inflation.

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