What's Up With Inflation?
Perhaps one of the most memorable periods of higher inflation are the years between 1975 and 1980, when the Consumer Price Index increased nearly 47% during that period and peaked at 13.5% (YOY%) in March of 1980. Since then, inflation has been relatively benign. Most recently, inflation is all the talk after beginning to rise in June of 2020. What is leading to the recent rise in inflation and how can investors and consumers be expected to combat the effects of inflation on their portfolios and their wallets? Let’s spend some time examining the history of inflation, it’s causes and effects, and then perhaps we’ll have some idea how to get ahead of the rise in prices.
A History Of Inflation
It would probably prove most helpful if we started with a sound, working definition of what exactly is “inflation.” Essentially, inflation is all about purchasing power— how much a unit of currency effectively buys of goods and services. The most commonly used index to measure inflation is the Consumer Price Index (CPI). That index measures the average rise or decline in price of goods and services in the economy. The rate of rise or decline provides us with an idea of how the economy is either growing or contracting. However, a dramatic rise or considerable decline in inflation could be troubling for consumers and/or investors.
Also related to the idea of inflation are the concepts of deflation and stagflation. It’s a good idea to mention them here to help solidify our working definition of inflation. Deflation exists when there is a general decline in the prices for goods and services. This situation exists when the supply of money is in contraction. Stagflation occurs when there is rising inflation accompanied by slow economic growth and relatively high unemployment (for example, from 1979 to 1982). Some economists have compared the current economic environment to a stagflation environment due to the current high level of unemployment. We would disagree with that notion as the most recent economic recession was not caused by underlying economic conditions, but the decision of policy makers to shut down the economy due to a pandemic. We will discuss this later as those policy decisions led to other perhaps unintended consequences with regard to labor and the supply chain. Suffice it to say, the economy has proven rather resilient despite being closed, re-opened, closed, and re-opened.
The most relevant way to understand inflation is through the eyes of the consumer. If consumers are not able to purchase sufficient goods and services because of a rise in inflation, it means the dollar (in the case of U.S. consumers) doesn’t go as far as it used to. This could force consumers to make choices on how they spend, and if the choice is to spend less, then the economy could contract as a result. That is the scenario facing consumers and investors today. Since Inflation bottomed out in May of 2020 as the pandemic was in full force, the growth in the Consumer Price Index is equal to 4.4%. You have to go back to 1991 to find a calendar year with greater than 4% inflation. An example of the effect of inflation can be seen in coffee— a key commodity. The cost of a cup of coffee in 1970 was approximately $0.25. Today, unless you’re visiting a Starbucks, the cost of a cup of coffee is approximately $1.60—an increase of 540%. Other ways in which inflation affects the economy can be seen in wage increases. Employers are offering higher compensation to entice people back into the workforce and fill the more than 9 million jobs currently available. Higher wages are inflationary and unlikely to go lower for the foreseeable future. One of the primary reasons why we believe that inflation will not be transitory overall is that employers are unlikely to cut employees’ compensation until the arrival of the next recession—likely more normal and driven by economic conditions instead of the cause of a pandemic.
As supply chain issues correct and some labor shortages ease, inflationary pressures on some goods could lessen. However, in a recent Kansas City Federal Reserve report1, 79% of businesses expect to pay more for materials and 69% expect to raise prices for their products as a result. In addition, 78% of businesses in that report state that they had to raise wages in order to attract or keep workers. Until extended employment benefits end from the pandemic, labor shortages will likely continue. A Morning Consult poll showed that 13% of unemployed have turned down job offers because they receive enough money from unemployment insurance.2 Companies are adapting, indicating that supply chain issues could self-correct. In the same Kansas City Fed report, 36% of businesses said they are turning away business due to supply chain issues while another 56% are increasing inventories. If business is turned away and/or inventories do not rise, consumers will be forced to reduce demand, thereby temporarily easing inflationary pressures. However, when supply chain issues correct and labor shortages end with pandemic benefits set to expire later this year, we expect inflationary pressures to pick back up on normal supply and demand functions in 2022 and beyond.
How To Combat Inflation
The Federal Reserve is maintaining the theory that the current rise in inflation is “transitory.” While we disagree, we do believe that inflation may turn slightly lower, before ultimately continuing to climb. Our position, therefore, is that investors and consumers need to be prepared for higher prices and wages in the future. We’ll review a few concepts that can help investors prepare for rising inflation within their respective investment portfolios and somewhat offset the negative effects of rising inflation.
The two phases of an investor’s retirement glidepath are the accumulation phase and the distribution phase. While an investor is employed and earning peak compensation, this is the time to invest often and to maintain an over-weight to equities since the time horizon is typically long until retirement. When an investor retires, the common misconception is that risk should be taken off the table. That strategy has worked to some degree over the last 20 years because inflation has been benign. However, going forward, inflation will erode the returns of bonds and cash in a retiree’s portfolio.
In the graph below, the 20-year annualized returns of several key asset classes, including inflation, is presented. Equities, as an asset class, typically offer the highest returns with the highest risk (volatility). Cash, on the other hand, typically offers the lowest returns with the lowest risk. Bond typically fall somewhere in-between equities and cash on the risk and return spectrum. However, when we have to account for inflation, the returns shown in the graph can become eroded on an after-inflation basis. For example, investors who held all of their investments in cash would actually have a real return (after inflation) of –0.7%, based on the graph. Conversely, investors who held all of their investments in equities would still have a real return of 5.4% after inflation. For most retirees, the risk of holding all of one’s investments in equities is too great. Rather, having an appropriate mix of investments in both equities and bond, like the 60:40 portfolio in the graphic, would be able to achieve a reasonable real return of 4.3% after inflation without all of the risk from a portfolio of 100% equities. For retirees going forward, the mix of 60% equities and 40% bonds could likely strike the balance between risk and staying ahead of rising inflation.
In addition to risk, investors need to take into account the costs of retirement that are affected the most by inflation. According to J.P. Morgan, the average inflation on health care is the greatest among the different spending categories in the graph below. For retirees, health care is one of the largest buckets of post-retirement spending as people age. The “other” category, which represents personal care products, tobacco, and cosmetics, was the third-highest category in terms of the effect of inflation. By maintaining a healthy exposure to equities during the accumulation phase of the retirement glidepath, retirees will typically have more money at their disposal for health care and personal care needs and have a greater ability to combat the effects of inflation.
With inflation likely on the rise in the coming years, working with your Financial Advisor to develop an investment strategy that helps your portfolio combat inflation is always a best practice. Develop a plan and stick to it. Your Advisor can help keep you accountable.
1. Kansas City Federal Reserve Bank (Tenth District Manufacturing Activity Increased Further - Federal Reserve Bank of Kansas City (kansascityfed.org))
2. Morning Consult Survey (Expiring Unemployment Insurance Could Add Up to Nearly 2 Million Jobs This Year - Morning Consult)
This report was prepared by Eudaimonia Asset Management, LLC and reflects the current opinion of the authors. It is based upon sources and data believed to accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Graph #1: Historical information for inflation obtained from the St. Louis Federal Reserve (Consumer Price Index for All Urban Consumers: All Items in U.S. City Average (CPIAUCSL) | FRED | St. Louis Fed (stlouisfed.org)). The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers.
Graph #2: Historical information for average inflation on different key spending categories obtained from J.P. Morgan Asset Management (Guide to Retirement | J.P. Morgan Asset Management (jpmorgan.com)). Data represent annual percentage increase from December 1981 through December 2020 with the exception of entertainment and education, which date back to 1993, and travel, which dates back to 2001. The inflation rate for the Other category is derived from personal care products and tobacco. Tobacco has experienced 7% inflation since 1986.
Graph #3: Historical total return information for different asset classes obtained from J.P. Morgan Asset Management (Guide to the Markets | J.P. Morgan Asset Management (jpmorgan.com)). Equities are represented by the S&P 500 Index. 60:40 portfolio is represented by a 60% allocation to the S&P 500 Index and a 40% allocation to the Bloomberg Barclays U.S. Aggregate Bond Index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Inflation is represented by the Consumer Price Index. Cash is represented by the Bloomberg Barclays 1-3 month Treasury Index. Indices are unmanaged. It is not possible to invest directly in an index.
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