2nd Quarter Client Note – Will Inflation Rear Its Ugly Head?

The S & P 500 (total return) index closed the quarter at a record high; up 8.55% for the quarter and 15.25% for the first six months, setting all kinds of winning streaks in the process.

The MSCI Developed Markets Index rose 5.65%, with Europe beginning to get more people vaccinated and its economy opening up. Emerging markets gained 5.05%.

Complimentary asset classes have been the leaders thus far in 2021. US REITs gained 11.76% in the quarter and are up 22.94% YTD. Reflecting the recent increase in inflation, commodities rose 13.30% in the quarter and are up 21.15% YTD.

As usual, our friends at Dimensional Funds comprehensively curate the data in their Quarterly Market Review.

The US economy continues to recover from the pandemic, with the various stimulus programs and nationwide vaccinations doing their job. However, risks remain.  The fiscal stimulus will eventually run its course. Supply chain (including labor) bottlenecks, pockets of vaccine hesitancy and the stubborn Delta variant overhang the economy.

Oh, and the Robinhood IPO. Reminiscent of the fabled story from the “Roaring Twenties” of Joe Kennedy deciding to cash out of the stock market in 1929 after receiving stock tips from his shoe-shine boy.

Interest Rates Down, Bonds Up

In a course reversal from the first quarter, the yield fell on the benchmark 10-year Treasury note from 1.74% to 1.46%. Total return on the Bloomberg Barclays US Aggregate Bond Index was 1.83%. Not enough to counter the first quarter’s 3.37% loss. But clearly the bond market “vigilantes” are not yet convinced that inflation is here to stay in a meaningful way.

Will Inflation Face the Nation?

Planning for inflation plays a critical role in any financial plan. What is inflation? As prices of goods and services increase over time, the purchasing power of a dollar (or any currency) diminishes. A modest amount of inflation necessarily accompanies economic growth. Inflation has historically hovered around 2-3% annually since 1926. At that rate, the prices of goods and services doubles approximately every 20 years. Of course, there have been periods of significantly higher bouts of inflation, causing consternation particularly among those surviving on a fixed income. Most recently in the 70’s and early 80’s, when inflation reached nearly 15%.

Fiscal stimulus, the Fed’s continuing accommodative monetary policy, supply bottlenecks and an improving economy have all precipitated a good deal of talk about whether inflation will increase to levels that would be economically destructive.  The Consumer Price Index rose 5.4% in June compared with one year ago, on top of a similar 5% increase in May, However, a couple of quarters (or even years) of dramatically rising prices coming off a pandemic induced recession does not amount to an inflation crisis. And lumber prices, an inflation bellwether, have recently fallen nearly 40% from their peak.

On the upside, the Social Security Administration is forecasting a 6.19% COLA adjustment to Social Security payments in 2022; the largest increase since 1983. This, after years of anemic adjustments. The 2021 COLA was 1.39%. Social Security is one of the best hedges against inflation in your retirement plan.

Economists are divided on whether we face the prospect of persistent high inflation. Prior to the pandemic, the world was in an extended period of low inflation. Despite herculean attempts, Japan has been unable to induce inflation in its economy. This colloquy between Dimensional founder David Booth and Nobel Laureate Eugene Fama suggests that it’s folly to try to predict what the rate of inflation will be, but that we should be prepared for it nevertheless.

How to Fortify a Portfolio Against Inflation

The inherent uncertainty in all of this suggests the best antidote is…diversification. Over the long term, equities have done especially well in combating inflation; producing a return on average of 6 – 7% higher than inflation. During periods of high inflation, “real” assets such as real estate and commodities tend to do well. But of course, these are the riskier asset classes, compared with cash and bonds, which barely keep up with inflation.

The trick is engaging in a sufficient level of advanced planning to determine the right mix of these various categories to meet your individual needs and tolerance for risk.

Concentration, Slip Away

There is little question but that valuations are stretched, particularly in US Large Cap Growth stocks. The big five, Apple, Amazon, Microsoft, Facebook and Alphabet make up 22% of the S & P 500 index. If that’s all you own, you’re not exactly diversified

Maybe it’s time to not love the one you’re with and diversify into less frothy areas of the market; including foreign holdings and a generous allocation into smaller companies and value (lower priced) stocks.

Keeping Your Cool in a Hot Market

While the US economy is poised to grow at its fastest pace in decades, this is no time to be complacent. To be a successful investor, temperament is everything. Nobody knows what that growth will actually look like or how long it may last. So, it’s best to stick with your well thought out plan. Don’t take more risk than you need to take to achieve your goals. And especially don’t worry about FOMO (Fear of Missing Out) on the next big thing. We should always be prepared for the next “black swan.” It may be lurking just around the corner.

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