To paraphrase Mark Twain: Everybody talks about inflation, but nobody does anything about it.
Inflation, simply defined, is the erosion of the purchasing power of money over time. It is a natural phenomenon in a growing economy. A ticket to the bleachers at Fenway Park cost my parents $1.00 when I was a kid. A bargain for them, combined with the 25-cent subway ride. Today a bleacher seat costs $25.00 and a Fenway Frank and a beer costs $15.00.
We financial planners have been talking about inflation for decades. Including projections and accounting for it in our clients’ long-term retirement plans. But at least through the duration of my fifteen-year planning career, inflation has been a relatively dormant 1 – 2% per year. Well under the long-term historical norms of 3 – 4%.
And it’s not exactly true that nobody does anything about it. Most people’s incomes increase along with inflation while they are working. Social Security has an annual built-in inflation (COLA) adjustment to protect retirees. The value of our homes and investments tend to increase. So, we don’t typically feel the corrosive effects of inflation. Except when it comes to paying for things that have increased by more than the general rate; such as college education and health care. Or, like now, when it gets out of control.
How Did We Get Here?
Famed economist Milton Friedman defined inflation as “too much money chasing too few goods.” Currency “debasement” has been occurring since time immemorial; long before anybody came up with a name for it.
The current version is mostly a demand side story; coupled with global supply chain shortages. As a consequence of an economic perfect storm (Covid, unprecedented fiscal stimulus and the war in Ukraine) we are currently experiencing inflation of around 7 – 10%, depending who’s measuring and what goods and services are included. We haven’t felt anything like this since the 1970’s and 80’s when the oil shock caused inflation to run rampant. But this actually may look more similar to the post-WW II inflation spike than the bout we experienced in the 70’s.
The Fed is trying to corral it with all the tools at its disposal: 1) raising short-term interest rates that banks pay to borrow from the Fed and from one another, and 2) selling longer-term bonds in the open market that it had previously purchased to add money to the system to combat recent financial crises. Both of these measures will tend, indirectly, to increase interest rates throughout the economy, such as on home mortgage and bank CDs.
But Fed Chair Jerome Powell is mindful that the cure can sometimes be worse than the disease. During the 1980s, then Chairman Paul Volker raised the short-term federal funds rate to 20%; setting off a double dip recession and raising unemployment to over 7%. A “soft landing” is no sure thing.
The Many Definitions of Inflation
The first line of defense against inflation is to be more conscious of your spending. Everyone has their own personal inflation rate, depending on their budget and lifestyle. The burger at your favorite spot now costs $20 instead of $12.99. Plane tickets and car rentals have gone up markedly; increasing the cost of travel. On the other hand, if you own your home, you are not subject to rent increases, etc. It remains a good idea to refrain from taking Social Security for as long as you can until age 70, to take advantage of the 8% annual benefit enhancement, compounded by the built-in COLAs.
Of course, some Americans are being forced into making hard choices.
Where Do We Go from Here?
Nobody knows the answer to this question for sure. April saw a slight tick down. The annual rate fell from 8.5% to 8.3%. But there continues to be sharp differences between core and non-core CPI from month-to-month. There are those who say we are headed for a prolonged period of Weimar or Mozambique style hyper-inflation. This is very likely hyperbolic rhetoric and one might question the motives of people that espouse such views.
It’s far too early to panic. The basic structure of the underlying global economy – which has harbored significant disinflationary trends – hasn’t change that much in the last couple of years. On the other hand, the situation we are in now should be taken seriously.
Looking at the price difference between “nominal” bonds and inflation-linked (TIPS) bonds, the “market” projects inflation of around 3-4%. The Fed is on course to continue its half-point increases until short-term rates reach somewhere around 3% by year-end.
Stocks may very well lose ground to inflation in the short run. But over the long term (10 years or more) stocks have historically held up very well.
Inflation, Interest Rates, Bonds and Stocks
Abnormally high inflation and rising interest rates cause investors to fundamentally recalibrate the relative attractiveness of nearly every asset class.
Bonds. After a 40-year bull market in bonds – the beginning of which coincides with the peak of the 70’s inflation when interest rates were pushed to 14% on government bonds – it’s a bit of a shock to see our bond portfolios losing value. This happens because the bonds (or bond fund) you own have lower interest rates than those that are available on new issues. To make your existing holdings equivalent in value to those with higher rates, the values must fall. The longer the maturity – or duration – of your current holdings, the more vulnerable to this phenomenon.
But there is a silver lining. As rates rise, your interest payments get reinvested in bonds with lower prices. If you are patient, over a reasonable period of time, you will get back to even; plus, own bonds with higher interest rates. And bonds will continue to be a good diversifier.
Stocks. For a number of reasons, rising inflation and rising interest rates also tend to put immediate downward pressure on stock prices. A slowing economy obviously hurts the growth and profit-making prospects of many businesses. Companies have a difficult time managing their costs structures and, depending on their industry and market power, may not be able to pass along enough of those costs to their own customers to maintain profit margins. Second, safer investments like bonds, become relatively more attractive by paying higher rates of interest; causing investors to consider reallocating their portfolios.
What’s an Investor to Do?
In the scheme of things, portfolios should already be positioned to withstand “normal” inflation; utilizing broad diversification and asset allocations consistent with the need or desire to take risk. There should be no need to make drastic changes. But you might consider small adjustments at the margins.
Investment Themes for Inflationary Times:
There is no perfect way to inflation proof your portfolio; especially over the short run. One thing to remember is that markets already factor in expected inflation. Unexpected inflation is another matter and can really challenge investors. Here are some ideas:
(These are not recommendations, but concepts to be discussed.)
Inflation Protected Bonds come in two flavors. I Bonds are savings bonds issued exclusively through Treasury Direct and available in fairly low annual amounts. And Treasury Inflation Protected Securities (TIPS). Both of these are complex products and have their costs and benefits which should be carefully understood before purchasing.
Commodities typically perform well during inflationary environments. The current period is no exception. The S&P GSCI Commodity Index rose 40.35% in 2021 and is up 37.63% YTD. But because commodities are an especially volatile asset class they should only be owned in small doses.
Equities have performed reasonably well as a long-term hedge against inflation. Especially those with rising dividends. Of course, equities suffer from short-term volatility in general. So, it doesn’t necessarily make sense to overweight them. But abandoning equities in response to short-term volatility doesn’t make sense either.
Real Estate has historically beat inflation. However, in many parts of the country real estate has performed unusually well over the past few years and some of those gains may already have occurred.
The future remains uncertain. Even the most “expert” of forecasts are likely to be wrong. Going overboard in any one strategy is likely to prove fruitless. So, we must carry on.