Economics is often called the “dismal science,” in part because of its poor track record at making predictions. Especially challenging is always determining whether something is a new long-term trend or just a temporary phenomenon. This has certainly been the case for inflation forecasts, not only over the past two years, but since the global financial crisis in general. What’s different now is that rapid inflation is rattling markets and consumers alike. How should investors adjust to a world of rising prices for the first time in decades?
Last week’s Consumer Price Index showed that headline inflation grew by 6.8% in November compared to a year earlier. Nearly all components of the index contributed to higher prices, including the cost of energy, cars and meat. This is the fastest rate of price increases in nearly four decades and an acceleration from last month’s reading of 6.2%. It is yet more evidence that prices could rise faster than expected for some time, despite protestations from politicians to the contrary.
For many, including the Fed, the defining word for inflation has been, until recently, “transitory.” Unfortunately, this has two interpretations. Transitory can be taken to mean “short-lived,” i.e., lasting only a few months or quarters, or “temporary” meaning that the effects are due to a one-time event and will eventually fade. And while these definitions are related, they have different implications for the global economy.
There are two different relevant points to make here. The first is that the Fed’s biggest historical success is arguably its handling of “stagflation” in the 1970s and early 1980s. By aggressively applying interest rate pressure, the Fed at that time was able to control inflation, albeit with recessionary side effects.
The second is that the inflation pressures that many feared following the 2008 financial crisis never materialized. There are a number of reasons for this, including the deflationary effects of technology and globalization at the time (which made goods more cheaply available) as well as more technical influences, such as the Fed paying banks interest on excess reserves (which increased the incentive to keep money parked at the central bank rather than lending it into the system).
Whatever the reasons, this time is undeniably different. While some long-term deflationary forces are still present, they are currently being overshadowed by the near-term effects of the pandemic, supply chain disruptions, excess demand for goods and services, a tight labor market, and rising energy prices. This makes it especially difficult to predict exactly when inflation might subside. And, even when it does, it could well remain above historical averages.
Though some of these forces are “temporary” in nature, it doesn’t necessary follow that they will fade quickly.
Where does that leave consumers? Rising inflation has already soured the mood among many households. Near-term inflation expectations are rising, and consumer sentiment is falling, especially among less affluent households. Yet many household balance sheets remain in a strong position and consumers are still spending. Unlike the 1970s, when the economy was contracting and the job market shrinking, inflation today is growing in the context of a robust economic expansion.
For investors, the key is to hold assets that can adapt to evolving inflationary environments without sacrificing too much diversification. Most diversified portfolios already include such investments, such as stocks (especially value stocks) and real estate. Established companies, for instance, have pricing power and can adapt to inflationary pressures over time. Similarly, rents tend to rise in tandem with inflation, not to mention that inflation tends to cause real asset values to appreciate over time.
That said, rising inflation may push up interest rates, which makes bond investing challenging. Even here, however, astute and patient bond investors can “ride the rate curve up” to at least maintain purchasing power over time. But if any asset class is especially vulnerable in these periods, it’s plain cash. Rising prices ruthlessly erode the purchasing power of cash. An inflationary environment flies in the face of the popular belief in the “safely” of cash.
Let’s take a look at three trends that may give you additional perspective about the current economic environment:
Inflation is the highest in almost 40 years
Last week’s CPI reading shows that consumer inflation is the highest since 1982. Much of this increase is due to food and energy prices. Yet even Core CPI has reached 4.9% – well above the notional 2% target that the Fed and other economists consider to be healthy.
Markets expect inflation to stay high in the near-term
Various market measures of inflation, including those implied by TIPS (Treasury Inflation Protected Securities), suggest that longer-term inflation could fall back to around 2 to 3% once short-term pricing pressures subside. Yet only time will tell. Once inflation takes hold it has a way of hanging on. Businesses and consumers alike anticipate and expect rising prices and wages, making both a self-fulfilling prophecy.
Consumers are feeling the pinchConsumer sentiment has fallen sharply in recent weeks, in no small part due to rising inflation concerns. Yet consumers are still spending, and demand remains high. It may take time for consumers to internalize their recent experiences and adjust to higher price levels than they have experienced over the past couple decades.
Over all, periods such as these should occasion a review of your spending plan no less than of your portfolio. Stocks and real estate securities are likely to do well, though growth stocks may struggle relative to their performance of the past several years. Established companies with pricing power should thrive. On the fixed income side, investors should look for a combination of investments that provide some yield while not accepting too much risk from sharp and sudden rises in interest rates or economic downturns. Finally, remember that cash is a terrible investment in periods such as this. It is anything but ‘safe’. Growth oriented households should decide what a prudent cash holding is, but hold no more than necessary.
As always, give your Griffin Black Advisor a call if you have questions about your portfolio or personal situation.