Inflation Complacency May be Dangerous (but so is overconfidence in one's ability to predict the future)
I apologize in advance for this rather lengthy post, but it is a complex topic.
With every financial plan, I talk about rising prices almost as a fact of life. And most of my clients accept that – sort of. Sure, most people retiring today have a distant memory of the inflation years of the 1970s and early 1980s, but it is a distant memory. Nearly 40 years of relatively stable prices have dulled the memory of what was a very painful time for many retirees living on fixed incomes. Incessantly rising prices can be difficult on any retiree - but fall hardest on those who rely on fixed pension payments for much of their retirement plan.
Like the boy crying wolf, inflation hawks have made a lot of noise in the ensuing years. Whenever monetary policy eased, or budget deficits soared, there would be loud warnings about the certain inflation to follow. But it never happened. And after decades of low inflation, it seems that the villagers (our public policy makers on both sides of the aisle) are dismissing the warnings out of hand, even as stock and bond markets are increasingly worried about increasing prices.
Inflation is all about supply and demand balance throughout the economy. And the economy can get complicated. For instance, inflation hawks screamed when the Federal Reserve started buying government bonds (aka “printing money”) after the 2008 financial crisis. The supply of money rose dramatically. But it never became inflationary because much of that money never made its way into the economy. There simply was not sufficient demand for that money in the form of consumer or business borrowing (which is ultimately how money makes its way from the Federal Reserve, through banks, and into the economy).
Toward the end of the last decade, fears about inflation started to rise again, as labor markets grew tight and employment costs on businesses started to rise. Surely higher costs on businesses would force them to raise prices, right? Well, not necessarily. A business can’t raise prices unless their competitors do as well, and competition from overseas suppliers meant that companies had to suck up those increased costs (or use technology to become more efficient). In fact, globalization of the economy is cited by economists as the primary force keeping inflation low over recent decades.
Well, the inflation fear mongers are at it again. Policy makers, no longer taking inflation hawks seriously, are doubling and tripling down on expansionary policies. Deficits jumped under the last administration following aggressive tax hikes. Under the current administration unprecedented sums are being put directly in the hands of consumers. Through it all the Federal Reserve continues to buy up the debt (aka print money) the government issues. More record setting spending bills are waiting in the wings. All this money is being pumped into an economy which isn’t really all that sick in the first place. It’s like force feeding stimulants to a guy after his sixth cup of coffee! It is true many lower wage jobs had disappeared due to the pandemic, but they are rapidly returning with the reopening economy. Unemployment at 6% pales in comparison with previous recessions.
Meanwhile, with money going directly to consumers, the government has found a way to force all this newly minted money into the economy, just as employment is recovering and employment is recovering. Economists are expecting demand to soar this year as people hungry to experience life spend all the savings they’ve been forced to accrue over the past year. Ports are already so backlogged that foreign competitors can’t rush to the rescue. Shortages of product or product components are already cropping up throughout the economy. Costs to companies are starting to put the squeeze on profit margins. As the labor market recovers, labor costs will likely resume the rise they started pre-pandemic – but this time overseas competition won’t be able to keep a lid on price increases due to congested ports and global supply shortages.
Inflation over the next year or two isn’t even in question, it is already happening. Housing prices are soaring, building material costs are skyrocketing, semiconductor shortages are driving up component costs for all manner of product. Food prices have jumped (although this may be pandemic driven as food processors globally have had production crimped due to COVID outbreaks). The big question is whether short term price increases are heralding a longer term cycle of inflation. When inflation persists, it can begin to feed on itself, as employees demand cost of living raises, consumers rush to purchase “before prices go higher” and companies raise prices in anticipation of future cost increases. Whether or not this happens depends a lot on how future government policy actions such as tax increases (which could dampen growth) and Federal Reserve actions on money supply.
So what does an investor DO to combat inflation? This is indeed a difficult question. If inflation were to really take hold like in the 1970s, the only cure is for the Federal Reserve to stomp hard on the economic brakes by raising interest rates and choking off the supply of money to the economy. Rapidly rising interest rates are not easy on anyone – but long term bond holders will be hurt the most of all! Think who would want to pay for (or own) a bond issued last year that will pay less than 1% for the next 10 years if interest rates rose to the levels of the 1970s! (hardly anyone is expecting that to happen…yet, but you get the picture) Stockholders might do a little better over the long run, since companies can maintain profits by raising prices – but if inflation results in higher interest rates, and higher interest rates result in a recession, there will likely be short term pain inflicted on most stockholders as well.
Perhaps the best inflation hedges based on historical performance are Inflation Adjusted Bonds (which should at least keep up with the rise in inflation), REITS (real estate companies can increase rents, and their real estate portfolios will increase in value), basic material and natural resource producers (benefiting from the rise in prices for the products they produce) and companies which historically grow their dividends – typically producers of everyday necessities. Technology wasn’t as big a part of the economy the last time we had high inflation, but some tech firms may benefit as companies seek to lower costs by improving productivity – but tech stocks with their lofty valuations tend to suffer more than dividend paying value stocks when interest rates rise.
Gold, contrary to popular belief, is not that great in inflation hedge. Over the long run, it tends to keep up, but it can be a wild ride. If you invest in gold on the expectation of higher inflation, but you get the call wrong, the risk of loss is substantial. Higher interest rates, used to fight inflation, have historically been like kryptonite for gold prices. Volatility and uncertainty diminish gold’s luster as an inflation hedge.
An unexpected source of inflation protection can come from the fixed income market. Short term government debt (Treasury Bills, or bonds maturing in a couple of years) may offer little return potential today, with exceptionally low interest rates. But if rates increase down the road, these higher rates will quickly start benefiting the investor.
Another unexpected possible inflation hedge may be found in some types of annuities. The insurance companies which issue annuities make more money when interest rates are higher. Higher rates can result in more attractive terms on some types of annuities such as fixed indexed annuities, or buffered annuities. We have been increasing our use of these products in recent years to provide additional diversification. (we only use low cost no-load consumer friendly annuity products – don’t wade into this market on your own!)
Unfortunately, it is never easy building a portfolio to fight inflation – because we can’t ever know if inflation will become a systematic problem or not! Let’s say we are completely wrong about inflation, and instead, the economy suffers some kind of shock which causes another recession. Stocks, real estate, treasury inflation protected securities, and gold – all our best inflation fighters - can all be expected to lose value. Short term bonds will not offer much of a haven from falling asset prices as their interest yield will fall even further. Those investments we may have spurned on expectation of higher rates and inflation will become the winners – especially long-term bonds.
We have been prudently building inflation protections such as TIPS and REITs into portfolios for some time. We recently had the good folks at Franklin Templeton do a stress test on the fixed income portion of our strategy, and they found it to be surprisingly resilient to both rising rates and recessionary events. At the same time we must remain broadly diversified. Sound investment strategy doesn’t involve predicting what the future holds – that is a futile effort. Rather, it means being ready for anything. It also means considering your own individual inflation risk when building an investment strategy. For instance, an individual who relies heavily on pension income for retirement might need to be more aggressive with their investment portfolio to counter the loss of purchasing power of their pension payments over time. Those who rely more on investments may be able to use more conservative inflation hedges such as Treasury Bills or TIPs. In short, there is no substitute for good sound, customized financial planning when creating an investment strategy.