When inflation comes, which market’s best?

Which stock market fares better during inflationary times? This was one of the questions Jim Otar, financial planner and founder of RetirementOptimizer.com, answered during a presentation hosted by CFA Society Toronto.

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“Canadian equities react to inflation differently than equities in other developed economies. Because of the higher commodity content, they protect portfolios against inflation better,” he says. Comparing Canadian and U.S. equities historically, he concludes:

• Secular bullish trends and low-inflation: Canadian equities lag U.S.
• Secular sideways trends and high-inflation: Canadian equities outperform U.S.
• Deflationary conditions: Canadian and U.S. equities perform similarly

Otar also cautioned against using popular Monte Carlo simulations to plan for clients’ retirements. The main problem with this approach, he says, is they assume random fluctuations around an average growth rate. But markets don’t behave this way.

The reality is markets exhibit long-term trends with considerable discontinuity from one to the next. Here’s the short version of the 20th century: Two decades of sideways movement is followed by a secular bull market. That’s followed by a black swan, which is followed by long-term sideways movement. Another long-term bull market follows. Then there’s sideways movement for 20 years, followed by a long-term bull market.

So, unless your client’s retirement lasts 100 years, the historical average return has no practical value.

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“Monte Carlo simulators also forget the correlation between interest rates, inflation and their influence on markets,” adds Otar. “They also don’t reflect black swan events properly.”

Asset allocation is also overrated, he says, when it comes to the distribution phase. “If [the client’s] withdrawal rate is larger than sustainable, then asset allocation has a minor impact on the probability of depletion.”

Otar lays out his alternative approach in a series of columns and CE courses for Advisor.ca:

Seven deadly sins of distribution portfolios

Determinants of growth in distribution portfolios

Purpose-driven sustainable withdrawal rate

Compendium of sustainable withdrawal rates, Part 1

Compendium of sustainable withdrawal rates, Part 2

Tweaking withdrawals for lifelong income