WHAT’S THE DEAL WITH INFLATION?

Michael Furla, CFA, CFP®

Inflation has recently been an increasingly hot topic for market pundits, government officials, Federal Reserve Board members and investors. In this discussion, we will go well beyond the causes of inflation and traverse frequently asked questions focusing on how inflation impacts investors.

In recent weeks, clients have asked us:

What is inflation?
What causes inflation?
What is causing the current rise in inflation?
Is inflation bad?
How does inflation impact my investments?
Which products and services are currently experiencing the most inflation?
Should I make changes to my investment portfolio?
What's to come?

Let's begin by diving into each of the above topics.

What is inflation?

Inflation is the decline of current purchasing power over time. More specifically, the cost of goods and services generally rises with time, so that a dollar today is worth more than a dollar tomorrow. A common method used to measure inflation is the Consumer Price Index (CPI), which measures the change in price for a basket of goods and services.

consumer price

Source: YCharts as of 6/10/2021
What causes inflation?

The three main causes of inflation are: increased demand, higher input costs, and higher wages.

  1. Increased Demand: is when there are not enough products or services being produced to keep up with aggregate demand, causing prices to rise. (e.g. semiconductors)
  2. Higher Input Costs: is when the cost of raw materials used to produce goods increases, forcing businesses to raise prices. (e.g. copper)
  3. Higher Wages: is when workers demand higher pay to keep up with the increasing cost of living, which causes businesses to raise prices on their products and services to offset higher labor costs. (e.g. Chipotle)

Source: YCharts as of 6/9/2021
What is causing the current rise in inflation?

There are many forces at play contributing to the recent pickup in inflation, including but not limited to:

  • Pent-up Demand: The pandemic prevented consumers from traveling, dining out, going to sporting events and halted other forms of consumption and entertainment. However, with the rapid development and deployment of vaccines, consumers stuck at home for the past year are now beginning to go out and resume normal activities as COVID restrictions are lifted. Given this, there is pent-up consumer demand which is fueling higher prices. An example of this is the soaring cost of rental vehicles.
  • Increased Savings & Labor Shortages: The savings rate increased over the past year due to the inability of consumers to spend money on services such as travel and entertainment coupled with generous unemployment benefits. In fact, it is estimated that 68% of unemployed individuals are eligible to receive more money via combined Federal and state unemployment payments than when they were still working. 1 The increased savings is dry powder for consumers to increase spending. Additionally, the generous unemployment benefits combined with health concerns about going back to work are an impediment to individuals reentering the workforce, causing labor shortages resulting in higher wages.
  • Accommodative Fiscal and Monetary Policy: Over $5 trillion in approved stimulus has increased the US money supply by $4 trillion in 2020 alone, an astounding 26% increase, the largest increase in US money supply since 1943.2 Furthermore, we must factor in the proposed $2 trillion infrastructure bill which, if passed, would fuel additional governmental spending. An increase in the money supply can lead to a weaker dollar and result in higher inflation due to the increased cost of imported goods.
  • Higher Minimum Wages: There is also growing momentum within the Administration and among various corporations (Amazon, Costco, Chipotle, Best Buy, Target, Starbucks, etc.) to increase the minimum wage to $15 an hour, currently the federal minimum wage is $7.25 an hour.3
  • Base Effect: To identify changes in inflation, economists must compare price data from different periods of time. It could be month-over-month or year-over-year. A year ago, during the onset of the COVID pandemic, prices fell due to government lockdowns and limited consumer spending, therefore, when we compare today's inflation readings to this period of abnormally low prices, the result is an unusually large increase in inflation. However, we must account for the abnormal circumstances of our base reading. This allows us to understand that part of the increase is a recovery in price vs a pure increase. Thus, when accounting for the abnormally low base, the increase may be less than what it appears to be.
  • Rising Input Costs: Rising costs of raw materials such as lumber have been a headwind to building new homes, which has in part fueled a longstanding housing shortage resulting in home prices to rise.
  • Supply Chain Disruptions: It is also important to note we are seeing challenges and disruptions with global supply chains. The pandemic was a wakeup call for countries to prioritize domestic production of critically important products and services versus importing them at a lower cost from overseas, such as personal protective equipment for healthcare workers. Additionally, supply chain delays in products such as semiconductors have exacerbated the situation as these chips are used in smart phones, electric vehicles, televisions, home appliances, and many other digital consumer products.2
  • Revised Fed Inflation Policy: Finally, a recent revision to the Fed's inflation policy now allows it to slightly overshoot its 2% target to make up for the past decade of low inflation. With this revision the Fed plans to maintain a 2% long-term average inflation rate.4
Is inflation bad?

It depends. Too much inflation is not healthy for the economy, savers and investors, which is why the Fed tries to prevent the economy from running “too hot”. However, too little inflation is also not good. Higher inflation harms savers by eroding their purchasing power; in contrast, higher inflation benefits borrowers, because inflation diminishes the relative value of their debts. Conversely, deflation, which is when prices fall over time, is dangerous to the economy since it incentivizes consumers to wait for cheaper prices before purchasing goods and services, which slows down economic activity and hinders growth. Central Banks target a 2% rate of inflation, which is believed to be a healthy amount. However, it is impossible to maintain a consistent 2% rate, because in reality, economies experience periods above and below this target. Over the past decade, inflation registered well below the 2% target, which is why the Fed is comfortable with letting inflation slightly exceed 2%, as previously discussed.4

How does inflation impact my investments?

Inflation's impact on investments is not uniform. Some sectors and asset classes benefit from rising inflation, while others are negatively impacted. For example, Wall Street analysts utilize Discounted Cash Flow (DCF) models to value companies. In these valuation models, interest rates are a key component for valuing future earnings, because as interest rates rise, the present value of future earnings fall and result in lower valuations. Therefore, rising inflation coupled with rising rates causes valuations for high growth companies, e.g. technology, to fall. This is one of the reasons we are currently experiencing underperformance for technology stocks and many large-cap growth companies. Conversely, investments tied to hard assets, e.g. real estate, gold and commodities benefit from inflation as their prices increase with it.5

  • Sectors & Asset Classes which have historically performed well during periods of rising inflation: 5,6
    • Small-Cap Stocks
    • Value Stocks
    • Real Estate / REITs
    • Commodities
    • Energy
    • Precious Metals & Mining
    • High Yield Bonds
    • Emerging Markets Bonds
  • Sectors & Asset Classes which have historically performed poorly during periods of rising inflation:5,6
    • Cash
    • Government Bonds
    • Long Maturity Bonds
    • Growth Stocks
    • Information Technology

Source: YCharts as of 6/9/2021
Which products and services are currently experiencing the most inflation?

Services sectors can expect the greatest impact from increased demand as reopening continues.

Biggest inflation drivers year-over-year include:7

  • Gasoline up 50%
  • Energy up 25%
  • Used cars and trucks up 21%

Source: The Irrelevant Investor
The above table shows the change in price from Sept. 2020 through April 2021
CPI – Consumer Price Index, used to measure the change in price for a basket of goods and services
MoM – month-over-month measurement period
Should I make changes to my investment portfolio?

Unsurprisingly, it is extremely challenging to predict the future, whether it's the outcome of the Kentucky Derby, interest rates or inflation. Because of this and based upon empirical evidence, at The Mather Group (TMG) we deploy a passive investment management strategy which replicates global market exposures. While small adjustments and fine-tuning will occur over time to remain in-line with our benchmark exposures, we will not attempt to make tactical shifts as a means to “time the market”. Therefore, TMG designs all-weather investment portfolios which are optimized for long-term, after-tax performance. Thus, our investment portfolios are designed to withstand bouts of elevated inflation, through the benefits of asset class diversification, tax loss harvesting and rebalancing.

What's to come?

If aggregate demand remains strong after the economy reopens, given unprecedented monetary and fiscal stimulus, the cost of production inputs such as labor could continue to rise. While it is impossible to accurately predict how high inflation will get, if at all, and for how long it will last, what is most important is understanding that what is happening is a normal part of the business cycle, and the possibility of hyperinflation is highly unlikely. The Fed has tools to combat excessive inflation and stated it will use them when needed. Right now, the Fed is focused on reviving and nursing the economy back to life. Additionally, technological advances are historically disinflationary over time, e.g. the PC, allowing economies to produce more with fewer resources. In the long run, technology will likely put downward pressure on inflation.8

It is important to us at TMG to not only stay on top of these market developments, but to provide timely insights for our clients so that they can confidently navigate through an everchanging investment landscape. A key component of weathering potential inflation is to maintain and update your personal financial plan. Please let us know if you have any questions or concerns. We are happy to discuss these topics and your individual needs in greater detail.

Sources & Definitions
1 Market Watch
2 Wall Street Journal
3 Business Insider
4 Board of Governors of the Federal Reserve System
5 iShares BlackRock
6 Bloomberg
7 Markets & Minds
8 Forbes
YCharts
The Irrelevant Investor
Federal Reserve Economic Data (FRED)

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