Much Ado About Inflation

Jun 7, 2024

Inflation has been a hot topic the last couple of years, so we wanted to shed some light on the status of the inflation saga.

Disclaimer: The short-term is dynamic and difficult to predict, so most one-year predictions are wrong. Ours included. What we do know about economics, however, is that many things tend to revert back to the long-term trend. That’s what we anchor to when building investment portfolios.

Having a strategy to mitigate the impacts of ongoing economic shocks, like high inflation, can be the best defense. Knowing that these things will happen along the way, but don’t last forever, is a huge advantage. We don’t predict, we prepare.

Why did inflation spike? Where is it now?

Remember that pandemic?

Well, that had a lot to do with it.

The US responded to the pandemic by issuing massive amounts of monetary and fiscal stimulus. As the world began to open again, all that cash and “pent-up demand” for things like travel and entertainment was a tsunami for the economy. Straight from Econ 101: “too much money, chasing too few goods” will create price increases. Voila, inflation.

That wasn’t all. At the end of 2021, supply chain issues and labor shortages began to pressure prices (used cars prices took off, for instance). Then in 2022, the pain train barreled on as the Russia-Ukraine conflict affected energy and food prices.

Thankfully, inflation did finally come off the boil after it peaked around 9% in June 2022 (as measured by the Consumer Price Index, “CPI”). More recently, the rate has been around 3.4%. Good, not great. The Federal Reserve wants to get that to 2%  – hence the reason for high interest rates, much to the dismay of the housing market.

But the Fed said this would be transitory!
Were they right?

It depends on how you define the term “transitory,” but at this point, the high inflation rates (say, north of 5%) were a short-lived phenomenon. Now the tougher question is: how long will it take to get inflation from roughly 3% back to 2%?

On one side of the scale, there are things that will keep inflation higher, such as onshoring, rising energy prices and a tight labor supply.

And on the other side of the scale, we have things like innovation, particularly AI, which may improve productivity dramatically. Higher debt and weakening demographics are also deflationary. It’s just a matter of how all these things weigh out in the balance.

Our View is this:

It’s likely we’ll see higher inflation in the coming years versus what we’ve been used to over the past few decades – our long-term financial plans include an estimate of 3% inflation. We hope we are wrong, but it is good to be prudent.

Are we going to see “hyper-inflation” like we experienced in the 1970s?

Probably not. A lot of you remember how awful that was. There were different circumstances then, and we’re not convinced we’re moving into an inflationary spiral with the current backdrop. At this point, the inflation rate has come down, so we feel this risk has diminished.

One thing that doesn’t get enough attention is deflation risk for the longer-term – much of this is tied to our aging demographics and high level of sovereign debt. Academics have been debating this for some time, and it’s important to remember examples of deflationary cycles, such as Japan and Europe, as much as the inflationary cycles like the US during the ‘70s.

No question, this warrants attention, but we view hyper-inflation as a lower risk. As mentioned above, slightly above-average inflation going forward seems more realistic.

What can I do to protect my wealth against inflation?

It’s true that inflation is a pernicious tax on your wealth over time – eating into your purchasing power little-by-little each year. Let’s face it, your dollar doesn’t get you as much today as it did 10-20 years ago, and it most likely won’t go as far in the next 10-20 years.

Make sure you consider inflation in your financial plan. It’s critical that your long-term rate of return not only meets your goals, but also keeps up with rising prices.

It’s a bit like swimming against the current, but right now you would need to make 3% per year to maintain “purchasing power” if the inflation rate is also at 3%. If you have all your money in a bank account paying you 0%, you’re going backwards. It’s time to make sure your money is getting you a positive rate of return AFTER inflation.

Gold and TIPs are often recommended for inflation protection. These assets can work if you know early when inflation is going to be higher than expected, but the evidence isn’t clear if owning these in your portfolio over the long haul really helps that much for returns. In other words, it feels good to see these asset prices go up during inflationary periods, but in the long run, you might be disappointed.

The better defense is owning good-quality businesses (namely, stocks) with strong pricing power, which is the ability to pass on input price increases to customers because demand is “sticky” even when prices go up. If these stocks continue to generate long-term positive returns due to earnings and dividend increases, then you should do fine over time.

We also believe bonds are important for your long-term asset mix. Bonds are generally not as defensive in inflationary environments, so it’s important to have a good investment manager for your bond allocation. There are many ways to get in trouble with bonds during inflationary periods, so having an experienced guide is key.

What’s the bottom line?

We constantly go through cycles of greed to fear, and back again. That much we can predict. Your best strategy is to build a solid plan, ignore the noise, and stick to it! Reach out if you have any questions or want to review your plan.

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