Should You Be Worried About Inflation?

According to the Bureau of Labor Statistics, US consumer prices for the year ending in June posted the largest annual increase since the recovery from the financial crisis started back in August 2008. Austin home prices are up 37.5% in the year ending in May, according to Redfin. Similarly, gasoline, lumber, and used cars are all more expensive than they were a year ago. Should we be worried?

Earlier this week, I shared an article on some social media channels by DFA’s Weston Wellington titled ‘Everything Screams Inflation.’ How to Interpret the Headlines. Wellington does a great job of illustrating how headlines don’t always (or even often) do a good job of predicting how markets may behave. But he didn’t address the question of if we should be worried about inflation.

I personally am concerned that we are being governed by two parties that have little or no regard for fiscal responsibility. Politicians seemingly can’t wait to spend our money, and our grandkids money, and their grandkids money on all manner of priorities and initiatives. According to the US Debt Clock, the US National Debt is now 128% of our Gross Domestic Product. If you divide the total debt by the actual number of taxpayers in the US, each one owes $227,474!

In spite of that sea of red, a bipartisan group of senators just hashed out $550 billion of additional spending on infrastructure to go with another potential $3.5 trillion or so in budget reconciliation spending being championed by Bernie Sanders. Democrats correctly labeled reconciliation as a “gimmick” during the Trump administration but have quickly adopted the practice as a work around to rules that are supposed to limit spending to actual revenue. It is that profligate spending that concerns inflation hawks, as cash flooding the economy can cause prices to rise.

Of further concern is the The Federal Reserve announcement back in April of this year that they were moving from a policy of “inflation targeting” to a more flexible “average inflation targeting”. The rationale is that since prices have risen persistently under their 2% inflation target since the 2008 financial crisis, that they can now afford to run higher than target for a while to average out around 2%. You wouldn’t be the only one that questions if that strategy is manageable given what we are seeing with our own eyes and feeling in our wallets.

Despite assurances from economists that recent price increases are “transitory”, it doesn’t seem too far fetched to assume this may be part of a longer strategy to manage the mountain of US debt by paying it off with cheaper dollars. That probably is the least painful way to try and get out of the mess we’re in, but the recent run up in prices has caused those of us that remember the 1970’s to recollect the extreme “stagflation” in which inflation and unemployment were persistently high.

Federal Reserve Chair, Jerome Powell, has said he doesn’t “expect anything like that to happen.” He also commented that what we’re experiencing during the reopening of the economy is “inflation in particular categories of goods and services that are being directly affected by this unique historical event that none of us have lived through before.” Let’s hope he’s right.

Some level of inflation, around 2%, is often considered normal. The 5 year Treasury Inflation-Protected Security (TIPS)/Treasury breakeven rate, which incorporates the market’s expectation of inflation, was 2.45% as of June 28th. Investor concerns have increased as indicated by the number of companies referencing inflation expectations during earnings calls. The below exhibit highlights how the number of S&P 500 companies mentions’ of “inflation” has tripled within the past year. This is not necessarily indicative of whether those companies expect higher or lower inflation, but rather that executives know it’s an important consideration for investors right now.

Market prices incorporate market participants’ expectations about the future. Therefore, market participants’ expectations about future inflation should be incorporated into current prices. These expectations are referred to as expected inflation. Unexpected inflation refers to unexpected changes in inflation that deviate from prior market expectations. Unexpected inflation should be considered a primary driver of inflation risk.

Some economists try to forecast future inflation, while some money managers attempt to trade on those forecasts. We do not know with certainty what inflation will be moving forward but without trying to predict it, we can still try to prepare for it.

We expect stocks to outpace inflation over time. Despite some periods where stocks may have lagged, one dollar invested in the S&P 500 Index in 1926 would have grown to more than $700 by the end of 2020 after adjusting for inflation. That is why we believe that even conservative portfolios should contain some exposure to the stock market.

However, some investors may be more sensitive to the volatility that comes with stocks. For example, someone nearing retirement may have a greater allocation to bonds. But some bonds are better than others at protecting portfolios from inflation. Treasury Inflation Protected Securities (TIPS), corporate bonds, and municipal bond strategies can all be useful in managing inflation risks.

Real estate is another asset class that should do well during inflationary periods. Historically, Real Estate Investment Trusts (REITs) have outperformed the S&P 500 in times with moderate to high inflation. REITs provides an excellent hedge against inflation in two ways. First, REITs can increase rents as new leases are entered into. Also, as we have seen recently, the value of real estate can also grow during inflationary periods. Furthermore, real estate is frequently leveraged, giving owners a dual benefit of a rising asset value they can payoff with “cheaper” money.

Gold and commodities are often touted for their inflation-protection but the evidence is unclear about their value in a portfolio as a hedge against rising prices. Gold has historically experienced high levels of volatility, and its relative inflation-adjusted performance has varied greatly depending on the time period measured. In fact, if you disregard the 1971-1974 period where US Investors were unable to own gold directly, the annualized compound return numbers are nearly cut in half.

Additionally, if you were to put gold in a vault and wait a decade, it’s value will reflect the current spot price, which is driven by supply and demand. Holding physical gold may also lead to negative cash flows due to storage and insurance costs. Finally, there is also an opportunity cost associated with buying gold – as you could be earning higher returns in other asset classes.

As for commodities, I’ll quote Ken French, Professor of Finance at the Tuck School of Business at Dartmouth College, “Finally, commodity funds are poor inflation hedges. Most of the variation in commodity prices is unrelated to inflation. In fact, commodity indices are typically 10 to 15 times more volatile than inflation. As a result, investors who use commodity funds to hedge inflation almost certainly increase the risk of their portfolios.”

Cryptocurrencies are also sometimes touted as a new value store that may replace gold. The 50% correction in Bitcoin this year has certainly not supported that view, however.

So back to the question of whether we should worry about inflation? We believe it is reasonable to be concerned. At ATX Portfolio Advisors, we are prepared for higher prices through portfolio construction. One way investors concerned about their future purchasing power can prepare is to include higher inflation scenarios in your financial plan to see how your plan responds to the stress of higher prices. If you haven’t reviewed your plan recently, it may not pay to wait. Get in touch to schedule a time.