Inflation Agitation
The American Rescue Plan is now law, which means that to combat a once in a century pandemic, one that has claimed almost 530,000 American lives, the U.S. government will have pumped more than $5 trillion into the $21 trillion economy over the course of 12 months. For all of the benefits of pushing money into the wallets of households and businesses, what could be the downside of the spending?
Glad you asked. As economists and analysts are lauding Congressional efforts to help low to middle income consumers, they are keeping a watchful eye on prices. After all, it stands to reason that prices will rise from last year’s abnormally low levels, once the economy reopens and people spend their rescue money and/or savings that they have accumulated.
Inflationary fears have come and gone over the past decade, but overall, sustained higher prices have not materialized. In fact, inflation is below where it was for much of the 2000s, prior to the financial crisis. The Consumer Price Index (CPI) was up 1.7 percent from a year ago. While that’s low, it marks an acceleration from the previous month. Concurrently, inflation expectations are increasing, and like many aspects of the economy and the financial world, expectations can drive the narrative more than the numbers, at least in the short-term.
Consumers are sensing a sea change in prices, according to the New York Fed's latest survey. Inflation is expected to increase above 2 percent over a one-year and three-year time horizon (that has not happened since 2014), and investors’ actions in the bond market indicate similar concerns. (When inflation rises, it is not good for bonds, because the fixed interest that you earn buys you less. That’s why the bond market has been dropping lately.)
Expectations can be self-fulfilling because if you are worried that you will be paying more for housing, gas, groceries and utilities, you may ask for higher wages. That in turn might cause businesses to charge more for goods and services, which could change inflation dynamics.
Officials are brushing aside these worries. Federal Reserve chair Jerome Powell said he didn't expect prices to increase to the point “where they would move inflation expectations materially above 2 percent.” When asked about whether trillions of dollars of government spending would spark inflation, Treasury Secretary Janet Yellen said, “I really don’t think that’s going to happen.”
Mark Spindel, the Chief Investment Officer of the District of Columbia Retirement Board (and a childhood friend of mine) explained why Powell and Yellen do not seem worried. Sure, inflation will rise, but that’s “mostly as a result of very depressed numbers from the pandemic onset last year.” Spindel projects that “in the medium term, inflation will settle back around 2 percent as it has been for most of the past generation.”
Diane Swonk, Chief Economist at Grant Thornton also doubts that U.S. inflation is about to take off: “much of the rest of the world is still fighting decelerating instead of accelerating inflation. This will act as another offset to inflation in the U.S., despite recent weakness in the dollar.”
If inflation does rise, Yellen says that the Federal Reserve has “tools to deal with that,” though some of those tools have not yet been tested, which is causing some of the agitation in the fixed income markets lately.
I have heard from many investors who are ready to throw in the towel on their bond positions, due to these inflationary expectations. Not so fast. Spindel advises investors “to think about their portfolios in a long-run, balanced way. If we are right that inflation remains reasonably well behaved, I think bond allocations can provide some needed diversification,” even if rates remain relatively low going forward.
HOW INVESTORS SHOULD PREPARE FOR INFLATION
Long term investors have one common goal: to grow their portfolios at a quicker pace than the overall rate of inflation, while also focusing on total risk levels. These asset classes can act as buffers, if inflation occurs.
Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. (I would add crypto/digital assets to this category as well.) However, this is a volatile asset class that can stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit exposure to 3-6 percent of the total portfolio value.
Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents.
Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might drop before reverting to the longer-term trend.
Treasury Inflation Protected Securities (“TIPS”): Rising prices can diminish a bond’s fixed-income return. To combat that conundrum, the U.S. government offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI.
International Bonds: Inflation can shred the value of the U.S. dollar so consider a small allocation to international bonds, which are denominated in foreign currencies.
While inflation may be looming, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.