INFLATION!....The buzzword for 2021 financial news, or as I like to call it, the crisis du jour.....Inflation is more often than not being presented by the media to investors as a big risk to their portfolios. But is it really? I've been getting a lot of questions from clients about this, so let's clear the air!
First of all....Moderate, steady inflation should not be viewed as a risk by investors. In fact, moderate, steady inflation in the 2-3% range is more a sign of a healthy economy than anything. It means demand is strong. It means wages are rising. It means unemployment is low. It means supply chains are working. It means the economy is cruising along and growing at a healthy rate. We should welcome moderate inflation. The way I look at it, as long as GDP growth (economic growth) is matching or outpacing the rate of inflation, things are good. So, if inflation is rising at 2% and the economy is growing at 3%, that is healthy. And that is what we have seen for several years....low inflation that has been outpaced by our economic growth rate.
So when is inflation bad?
Well inflation is bad when prices are rising and the economy is stagnant or shrinking. This is a phenomenon called "stagflation" and it is harmful. If the economy is shrinking and employment is shrinking while prices are rising, this only exacerbates the economic issues and causes bigger problems. If my income has dropped but the price of food and gas has gone up, that puts me in a really compromised position as a consumer. That is NOT what is happening right now.
So what is happening right now? Why is inflation so much in the news? Well, it's due in large part to the COVID crisis. I'll explain....
If you think back to where we were 12 months ago....Prices were actually falling because there was very little consumer demand. We were all locked down inside our homes unable to go out and participate in the economy so consumer demand dried up. Lower demand = lower prices. Now fast forward 12 months to today and the economy is re-opening and we as consumers are going out and spending a lot of the money we saved up during the crisis when we were stuck inside unable to go out to eat, go to the mall, go on vacation, etc...This is the "pent up demand" we have heard so much about over the last 12 months finally getting released into the economy....so there has been a huge surge in consumer DEMAND recently which is causing prices to rise. Higher demand = higher prices. There are also issues causing supply bottlenecks which is reducing supply at the same time demand is rising which is compounding the forces causing prices to rise. Without getting too deep into the supply side...I believe these bottlenecks are transitory and will be alleviated over time which will help reduce the upward pressure on prices. Now here is why what I've just explained is important...
Inflation is typically measured by year-over-year change. Put plainly: How much have prices risen from where they were 12 months ago?
Well, a year ago prices were falling due to a health crisis. Today, prices are rising because the economy is re-opening and demand is increasing quite abruptly. So when we calculate year-over-year inflation, we are comparing todays price levels to a very low point which is producing a higher than usual year-over-year change number of 4-5%. But If we zoom out and actually measure the rate of inflation over 2 years which removes this comparison to the low point in 2020 caused by COVID, the longer term inflation rate from 2019-2021 is right back down to the 2ish% number we are use to. No big deal... And as we move forward, I expect that after a transitory period of higher than usual inflation figures caused in part by these comparisons to last years low points, we will see year-over-year inflation numbers return to more normalized rates. I could be wrong, but this is the opinion I have formulated based on a lot of the research teams I trust and follow.
So why is the news so focused on the artificially high year-over-year figure? You know why....because it's more scary that way and the media THRIVES on selling us something to worry about.
Now...having said all of that...what can investors due if they are worried about sustained higher inflation? What if this higher inflation is not temporary?
First of all, they probably shouldn't leave the stock market. One of the biggest reasons we invest is so that our savings can outpace inflation over time which preserves the purchasing power of our assets. If beating inflation is part of the reason we invest, we certainly shouldn't abandon our investments if we think inflation is on the rise. There may be adjustments we want to make within our portfolios regarding the types of sectors we are investing in...but it's probably unwise to abandon stocks altogether due to inflation.
Second....Cash is basically a guaranteed loser. While the media will use inflation to try to scare you out of your investments, you have to ask yourself....where do the proceeds go? Cash? Cash is the one guaranteed loser to inflation. Inflation is literally by definition the reduction in purchasing power of a dollar. So if inflation is, say, 4%....the value of cash is being reduced by 4%. As inflation rises, the rate of depreciation of our dollars also rises. Now why would we want to INCREASE our allocation to something we know is losing value? Well, we probably wouldn't. If I told you your stocks were guaranteed to lose 4% a year moving forward, you'd probably not be rushing to invest more into stocks.
Third....Bonds....most bonds don't love high inflation, and here is why. If inflation persists at a rate higher than the Federal Reserve would like for too long, they will use their tools to reduce inflation. One of their primary tools for doing so is interest rates. The Federal Reserve can control interest rates to a degree and if they want to slow down inflation, they'll raise interest rates. This is bad for most bonds. Bond values and interest rates move inversely....so if rates are on the rise, bond values are likely to fall. However, just like with stocks, there are certain types of bonds that perform better than others in inflationary environments....so if inflation persists, it may be beneficial to identify and increase exposure to those.
Bottom line....don't fall prey to the fear machines on your televisions. The people you're listening to don't care if you make or lose money, they only care that you keep watching. Better to follow the advice of the folks around you that are paid to care about your financial well-being. Whether inflation runs hotter for longer or is simply here today, gone tomorrow, your advisor should be able to formulate a game-plan that works for you.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. The opinions and other information contained in this article are subject to change based on market or other conditions. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. There is always a risk when investing in stocks, including the potential to lose principal. Generally, the greater the risk, the greater the potential reward. You should determine your risk tolerance and financial goals before deciding to invest. Investing involves risk and the potential to lose principal.