We have been hearing a lot of discussion lately surrounding the possibility for higher inflation and its potential ramifications on the markets. In fact, the threat of inflation is what spooked equity and bond markets in the final week of February as the yield on 10-year Treasuries spiked to its highest level in a year, briefly touching 1.6%. Given the record amounts of pandemic-related economic stimulus transpiring, it makes sense that we’re hearing talk of inflation. If inflation were to result from all this stimulus, what would that look like in today’s environment? And what could that mean for the markets and your portfolio?
First, let’s start with the definition of “inflation.” Inflation is what occurs when the cost of goods and services like food, gasoline, TVs, housing, and healthcare increases. The risk we face, as the U.S. Government continues to pass further stimulus bills, is that the economy may not be able to handle the influx of new money without seeing an increase in the prices we pay as consumers.
Now, some of you may be thinking, “Inflation is already here – just look at my healthcare premiums and the cost of college tuition!” On the other hand, there are some items, such as TVs and computers, that have actually had significant price decreases due in large part to technological advances and world trade. Overall, this has resulted in a subdued overall inflation rate over the last two decades. Economics Professor Mark Perry of the American Enterprise Institute created a somewhat famous chart that he updates annually that illustrates this phenomenon:
The Federal Reserve actively targets a two percent overall inflation rate in the long run as part of its mandate to achieve full employment in the economy. The U.S. has been extraordinarily lucky over the last few decades since we haven’t experienced rampant inflation, nor have we experienced inflation’s ugly twin, deflation.
What would a world of higher overall inflation than we’ve become accustomed to look like? In some areas of the economy, inflationary pressures are already present even without the economy having returned to a fully reopened status. For example, according to Ned Davis Research, the price of lumber has tripled since its April 2020 lows, fueled by surging housing demand coupled with pandemic-related supply chain disruptions. As a result, any products that take lumber as a key raw material input will have a higher price tag.
As we look to the future, an easy inflationary scenario to imagine is that as we exit the COVID-19 pandemic suddenly everyone wants to take a vacation, and the price of flights, rental cars, hotels, theme park tickets—and anything else associated with the traditional American summer vacation—increases by a noticeable amount. While these examples may seem relatively isolated, higher prices in one area can have ripple effects throughout other areas of the economy as well. If enough pockets of the economy see simultaneous price increases, the overall inflation rate will rise faster than expected.
Currently, the consensus among economists and professional investors is that 2021 will, at the very least, experience a temporary pop in overall inflation from continued economic stimulus and a reopened economy where consumers spend money that they weren’t able to in 2020. While it may be irritating to have to pay more for a product or service as we compete with other consumers, the alternative of everybody being unable to go out and spend money is far more detrimental to the health of the economy.
If the overall rate of inflation gets above 4% on a sustained basis, problems can arise. Some readers may recall much higher rates of inflation in the 1970s (above 10%) and the headaches that came along with it as paychecks were not keeping up with the pace of the rapidly increasing prices of food, rent, and gasoline. The image that my generation (Millennials) often associates with this time period is of the 1973 Oil Crisis when a culmination of inflationary events was met with a Middle East oil embargo, resulting in consumers lining up for hours to fill their gas tanks.
While we are far from this level of detrimental inflation, a higher level of inflation is what spooks older economists and market practitioners because they lived through this nightmare that younger generations only know by name. As current Federal Reserve Chairman Jerome Powell recently said in January, “The kind of troubling inflation that people like me grew up with seems far away and unlikely.”
While historical stock market returns during inflationary periods are mixed, a higher inflation rate can have plenty of varying effects on the markets, from a boost in the stocks of energy-producing companies to a decrease in the price of treasury bonds, both of which we have already witnessed in 2021.
We are constantly monitoring the markets to allocate towards areas that are outperforming, regardless of what the macroeconomic backdrop is. Presently, we have been shifting some of the equity allocations of the portfolios towards funds composed of smaller companies (also known as “small-caps”) and international companies. Both have been areas that have done extraordinarily well since November. We also recently allocated towards some value-oriented funds that will benefit if energy prices continue to rise.
As an active manager, we have an advantage in that we can quickly pivot to capitalize on new market trends as they emerge. If we do, in fact, enter a period of higher inflation, we will adjust the portfolios as necessary to protect against—and even benefit from—rising inflationary effects.
Disclosures are available at https://fsainvest.com/disclosures/market-update/.