The big theme of the last few weeks has been investors trying to anticipate what happens 6-18 months from now with inflation and interest rates. Here are some possibilities:
1) High Inflation, High Interest: Inflation zooms up to 4% or higher upon post-pandemic reopening and pent-up consumer demand. Unemployment dips below 5%. The Fed raises rates by 2% in a series of moves starting in 2022, and dials back QE. Stocks and real estate enter a multi-year bear market by the 2nd half of 2021, in anticipation of the rate increases. In late 2022, a number of funds and financial institutions nearly collapse from losses in the bond markets, and a financial crisis occurs. Whereas "CDO's" was the new term everyone learned in 2008, "bond convexity" is the term everyone learns in 2022.
2) High Inflation, Low Interest: Inflation zooms up as described in #1, but the Fed takes a wait-and-see approach with interest rates, as they've already said they would, because they've spent the past 20+ years missing inflation targets and killing expansions by prematurely raising rates. Some investors begin to fret about a return to the 1970's, and their selling roughly balances the benefit of low interest rates for corporate and margin debt. Stocks and bonds have a choppy but roughly flat couple of years in nominal terms. Real estate and commodities boom. Stock valuations normalize despite the low interest rates, creating attractive arbitrage opportunities between borrowing rates and earnings growth, especially for commodities companies.
(3) Low Inflation, High Interest: The narrative shifts from inflation panic to bubble panic as the Fed makes statements of concern about the threat of asset bubbles in investments and real estate. In a scene reminiscent of the series of rate increases in 1999-2000, the Fed raises rates 1% in a series of moves intended to ensure inflation doesn't get out of control and to deflate asset bubbles. Stocks and real estate enter bear markets, while bonds are modest losers. For the throwback giggles see:
https://money.cnn.com/2000/03/21/economy/fomc/4) Low Inflation, Low Interest: Inflation reaches 3.5% in the summer of 2021, only to retreat back to 2% by the first quarter of 2022. The Fed, true to its verbal commitment, holds rates low during this time and continues QE. It appears the US is back on its decades-long trend line of low inflation and low interest rates, driven by the same disinflationary forces that have held down inflation for over a decade. Stocks and real estate boom as we proceed through another multi-year bull market similar to 2009-2019 or 1992-1999.
My vote is that #4 happens. If I was to rank their chances, I'd pick:
#1: 10%
#2: 25%
#3: 10%
#4: 55%
According to this estimate, I should maybe target the commodities and REIT sectors (particularly mREITs) in order to get the combined odds of #2 + #4, but in reality such a strategy might do worse than the market in the event of #4 and these companies may be too richly valued to do better than bonds in #2. Plus, I'd be increasing my exposure to the high inflation scenarios of #1 and #3, in which leverage and dependency on capital markets would be severely punished.
Conclusion: Sticking to index funds.
