Much Ado About Inflation: Part 2

May 26, 2022

We talked about inflation in a piece about a year ago, and as we’ve always said: the short-term is dynamic very difficult to predict, so we’ll likely be wrong. Even “professional” economists rarely get things right, consistently. What we do know is in the long-run, things do tend to revert to the long-term trend-lines and having a strategy to mitigate the impacts of ongoing economic shocks, like high inflation, will be the best defense.

Why is Inflation so high?

Initially, inflation statistics were impacted by “Base Effects.” This just meant that inflation was justifiably high because we had a low comparison point from the prior year when the world was in an economic free-fall and experienced deflationary price movements. Essentially, it’s just the math of going from 0 to 60 in a relatively short period of time.

Also, keep in mind that the US responded to the pandemic by issuing massive amounts of monetary and fiscal stimulus. As the world began to open again, consumers had a lot of cash and “pent-up demand” for things like travel and entertainment. Straight from Econ 101: “too much money, chasing too few goods (or services)” will create price increases.

These things would have seemed to be short-lived; however, we found that inflation continued to accelerate into the end of 2021 as supply chain issues and labor shortages began to pressure prices (used cars, for example, had a large impact on inflation data as new car supply seized up). Fast forward to this year, and the pain continued as the Russia-Ukraine conflict exacerbated the situation by creating problems for energy and food. The good news, is that it does appear inflation could be peaking, and we expect that many of the drivers of inflation so far should begin to taper from here.

The Fed said this was transitory. Were they wrong?

Depends on how you define the term “transitory.” Given that many of the variables behind the high inflation appear to be shorter-term issues related to the economic reopening, supply chains and geopolitics, it would seem so, but it will take longer than hoped. It is also very difficult to predict how things will play out in Eastern Europe, so we will remain just cautiously optimistic.

The old adage is: “the cure for high prices is high prices,” so we are starting to see people make decisions that could ease the current pricing pain. With higher interest rates, we are seeing that people are becoming less likely to buy a new house in the next year if they don’t need one. Or higher airline tickets will start to crimp the demand for travel. Especially when the consumer cash balances get depleted, consumers will think twice about using that credit card with a floating (and increasing) interest rate.

Now, we should also say that it does seem likely that we’ll see higher inflation in the coming years versus what we’ve seen 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 though. However, there were different circumstances then, and we’re not convinced we’re moving into an inflationary spiral with the current backdrop. The Fed is on a path to work very hard to get this under control, even if that means creating a mild economic slowdown (and we’re hoping for the “soft landing” if that does occur).

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 (especially after the pandemic stimulus). Academics have been debating this for some time, and it’s important to remember examples of deflationary cycles (such as Japan, Europe) as much as the inflationary cycles like the US during the ‘70s. No doubt, this all warrants attention, but we are not sold that hyper-inflation is the most likely scenario – as mentioned above, slightly above-average inflation for several years ahead 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 bit-by-bit each year. Let’s face it, your dollar doesn’t get you as much today as it did 10-20 years ago, and it likely won’t go as far in the next 10-20 years.

So, it’s important to consider inflation in your overall financial plan and to have an investment strategy that aligns with your need to preserve purchasing power (meaning, the ability to buy the same amount with your wealth in the future as you can today).

Regarding investments, frequently gold is recommended for inflation protection. It might work if you know when inflation is going to pop up, but the evidence isn’t clear if owning it in your portfolio over the long haul really generates sufficient real return (in other words, it feels good to see it go up during inflationary periods, but in the long run, you might be disappointed since it doesn’t actually “produce” income).

The better defense is owning good-quality businesses (namely, stocks), particularly those with strong pricing power (the ability to pass on input price increases to customers because demand is “sticky”). If these stocks continue to generate long-term positive returns due to earnings growth and dividend payments, while giving you a “raise” when you need it during the inflationary years, then you should do alright over time.

We also believe fixed income (bonds or “debt”) is important for your long-term asset mix. Bonds are generally not as defensive in inflationary environments (as we are witnessing in the market currently), so it’s important to have a good investment manager for your fixed income allocation as there are things that can be done to mitigate the impact of inflation on this asset class.

The bottom line here is that we constantly go through cycles of greed to fear and back again. But your best strategy is to build a solid plan, avoid the noise and stick to it!

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