Inflation’s Impact - Consumer vs. Investor
Nothing has captured the conversations and questions from clients in the 2nd half of 2021 as much as “Inflation”. As the chart below shows, it has been a rare impact for much of the last 30 years (besides the early 90’s and the housing-fueled runup in the mid 2000’s) and the words “Inflation” and “Hyper-inflation” spur memories for those approaching and in retirement of the mid-70’s to early 80’s where both inflation and interest rates hit staggering levels we haven’t seen since.
So how should we think about inflation now and what can/should we do as both consumers and investors? It is an evolving conversation, but here are some key aspects to consider.
First off, it is important to be aware of that distinction for yourself. You are a consumer and you are also an investor. Negative impact to you as a consumer doesn’t necessarily equate to an equally negative impact to you as an investor.
You, the Consumer - Unless you are the ultimate hermit (who happens to have the technology to read this) you have already experienced inflation’s impact as a consumer – gas prices, home prices, rental prices, car rental prices, food prices, etc.
Year over year measured inflation ending in October was 6.2% with October alone up .9%. The sectors with the highest increase in prices, according to the Washington Post.
Fuel oil – up 59%
Gas – 50%
Utility – 28%
Used Cars – 26%
Hotels – 26%
Washing Machines – 15%
Furniture – 12%
TVs – 10%
The cost of a well-rounded Thanksgiving meal was up 14%. Other “Meatflation” and food increases:
Steaks – up 24%
Bacon – 20%
Pork Chops - 16%
Eggs – 12%
Fish – 11%
Chicken – 9%
Milk – 6%
The only two sectors that didn't show increases in prices in October, per the federal government, were alcohol sales and airfare.
These are all tangible impacts to your cash flow that have been greater than wage growth for most people. While labor shortages have driven up wages in certain industries and have allowed some to move up the ladder from lower to higher paying jobs, the average salary increase in 2021 was 3% and is projected the same for 2022.
The roughly 70 million Americans who receive Social Security and/or SSI will receive a 5.9% increase to their benefits in 2022, which is a significant increase, but many older adults on fixed incomes from other pensions that don’t increase are feeling the pinch.
The 2 main questions have been 1) How long the high rate of increases will continue and 2) Will they eventually come back down?
The key buzzword has been “Transitory” – is inflation the result of things that will work themselves out from a crazy pandemic and calm down or a longer-term structural trend?
Arguments for it to be more Transitory have been the major supply chain shortages in US and abroad coming out of the pandemic combined with massive pent-up demand from the lockdowns, an expected return to spending on experiences more than goods, and eventually demand slowing down from enhanced unemployment and other stimulus checks running out as well as just from the rate of inflation itself.
Arguments that inflation could stay higher for longer have to do primarily with the massive amount of fiscal stimulus that has been injected into the economy (with more still in the process of debate in Congress), the continued strong desire for housing with low interest rates, and the labor shortage with millions of unfilled jobs that has caused certain industries to pay up significantly in wages and pass those increased costs on to the consumer.
Fed Chair Powell finally acknowledged this week that use of the T-word should be “retired” since it tends to make people think “it won’t leave a permanent mark in the form of higher inflation”. The original stated intent was to help note that readings comparing year over year from COVID pricing lows would be unusually high, but the hope was that it would fade as the year progressed. That hasn’t happened and many feel like the Fed has been behind the curve in dealing with it. Powell acknowledged that the “risk of higher inflation has increased”, but still has a baseline expectation of 2% over the course of 2022.
In my opinion the answer is not whether inflation is either Transitory or more permanent. It seems clear that certain issues related to supply chain and demand will be slowly resolved further as we go into 2022 and unique pricing pressure from that will come back in certain areas that people won’t have to “pay up” as much to get scarce goods like rental cars and refrigerators. However, it also seems unlikely that a lot of other increases can be unwound, especially as they relate to higher costs to companies related to wages. You aren’t going to see companies saying to employees “Inflation is getting back to normal so we’re going to cut your wages back to where they were”. They’ve passed those expenses on to you, you grumble a bit, but then they soon become your new expectation.
You, the Investor – So with all of this inflation talk we need to get out of the markets and protect ourselves, right? Most people who lived through the 70’s recall it as also not being a good stretch for stocks. Inflation also peaked briefly in 2008 just before the Great Financial Crisis. The other time above 5% year over year inflation in that time was the late 80’s to early 90’s. We can see that in the 70’s (and obviously in 2008) the stock markets had a tough 1 year stretch, followed by recoveries. The 89-90 period had strong stock returns anyway. Obviously none of them had a global pandemic with global economic shutdowns to navigate impacting the inflation narrative, but they are worth looking at closer.
The key takeaway for long-term investors should be that despite the high inflation situation that started each of these periods, stocks ended up 10 years later with double digit return averages that were 4-5%+ greater than the other assets classes annualized at the end of that period of time. Investing in the growth of companies over time has been a winning strategy, regardless of the short-term noise (whether from inflation or anything else).
The biggest issue in my mind for how returns will look in the short-term (next year or so) is how well the Fed and policymakers communicate about and navigate the delicate balance between 3 areas:
Inflation
Interest Rates
Stock & Bond Market Valuations
The standard antidote to combat increasing inflation is to increase interest rates. Thinking about it from a home buying perspective is easiest for most people. As interest rates increase there are fewer people who can qualify for a loan to buy a home at any given price. That in turn (in theory) would be fewer people chasing that same house and not bidding up the price in the same way. Increasing rates in moderation would still likely allow the house to sell in the expected range, but not have the crazy appreciation we’ve seen from rabid buyers. Significant increases in interest rates would likely start to have a negative effect on the home prices as buyers realize they aren’t interested in paying the borrowing costs.
Similar calculations are done by companies as it relates to their growth plans and their borrowing costs to do so. Increased costs may lead to scaled back growth plans. As future growth prospects slow down, the perceptions of the value of those companies would go down as well. This can have an outsized impact on companies relying on access to outside capital to fund their anticipated growth and less on companies with strong balance sheets to need to do less borrowing.
This is obviously also true for households. Low interest rates have been a big boon to people buying homes and other items as well as those refinancing existing loans, but it’s been a killer for savers. Look at those charts of the returns from 1972 and 1989 to see money markets at 13% in the early 80’s and 6-8% in the 90’s. Since 2008 they’ve averaged less than 1%. Savers who have their borrowing costs under control or eliminated cheer the idea of interest rate increases. As long as it doesn’t dramatically impact their stock and bond investment holdings.
Bond Impact
This is where that delicate balance comes in. While increasing interest rates are a positive for savers, they are a clear short-term negative for the value of existing Bond/Bond Fund holdings. Bonds are debt instruments where the company/government/municipality borrows money at a certain interest rate with a promise to pay it back. Investors can hold on to that bond until it’s paid back with principal and interest or they can trade it on the bond market to someone else.
In a simplistic example, if I’m holding a bond from a company that’s paying me 3% interest and interest rates increase to where you can now get a bond from that same company paying 5% interest, are you going to give me 100% of what I paid for my bond if I want to trade it? No, you would do a calculation to determine a lower valuation of my bond that would give you the same yield you could get with the 5% option. All of this happens naturally in a bond market as interest rates and yield calculations occur. The point is, your existing bond and bond fund holdings become less valuable as interest rates increase. This is what led to the worst quarter for bonds in roughly 40 years in the 1st quarter of this year when the 10 year treasury just increased from .93% at the beginning of the year to 1.7%. See the charts below from YCharts.
Interest rates calmed down a bit the remainder of the year so far and bond returns have held steady, but this is certainly why there is plenty of concern about the outlook for bond returns in a rising rate environment. Bonds play an important role historically in portfolios for more conservative and moderate investors to smooth out returns, because although that drop looks huge, that worst bond quarter in 40 years was down only 3-4% compared to the 30%+ drops of stocks at the beginning of COVID or in 2008.
The market expectations have been for the Fed to increase rates for the first time in a couple of years by mid 2022. Navigating that and deciding whether elevated inflation means they need to push that up sooner will be important. How they communicate it is also important since the market doesn’t like surprises and hopefully the Fed has learned lessons from that from the 4th quarter of 2018. It’s one of those things where we know we probably should increase rates from the low levels they’re at, but certain players, including our own Federal debt situation, benefit from low levels.
Ben Carlson in his blog, A Wealth of Common Sense, always has a lot of good facts and figures to do our best to make sense of things. A couple of them are relevant here – Some thoughts on the highest inflation in 30 years and Why aren’t interest rates higher?, from which comes the following chart showing how far from normal the inflation vs 10 year treasury spread is.
Despite all of this, bonds remain a key part of the portfolio for investors who value lower potential for the significant declines that can come from stocks and who value preservation and/or income in their portfolios as much or more than the long-term growth opportunities from stocks. It remains a delicate balance and we have been using and continuing to research investment options that help us to bridge the gap of more return potential than aggregate bonds while still less risk than the broad stock market.
Stocks Impact
Stocks can do well in higher inflation environments historically as long as it remains relatively controlled. In fact, the worst returns for the markets have come in very low inflation or deflationary time periods, with above 4% being next worst, but still historically on average within levels that most people would be just fine with.
Rolling 12-month average total return (%) across headline CPI levels
Source: FactSet, Federal Reserve Bank of St. Louis, 11/30/1979 to 9/30/2021. The Russell 1000 Value Index tracks the performance of publicly traded large-cap companies in the United States with lower price-to-book ratios and lower forecasted growth values. The Russell 1000 Growth Index tracks the performance of publicly traded large-cap companies in the United States with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Index tracks the performance of approximately 800 publicly traded mid-cap companies in the United States. The Russell 2000 Index tracks the performance of approximately 2,000 publicly traded small-cap companies in the United States. It is not possible to invest directly in an index.
Again, from the chart above and the chart below we can see that high, rising inflation that remains high and rising for long periods of time has been less favorable for the markets over shorter time periods, but it’s just hard to know how much we can really draw similarities to the 70’s when most of that occurred. It’s hard for me to currently imagine a scenario where year over year inflation beginning around April of 2022 will still be in the 4-5% up range from the elevated levels of 2021 when all of the elevated readings we’ve been seeing this year have been compared to the COVID deflationary impacted prices of 2020. It just seems like too many of the shorter term reasons we listed earlier for why some of it seems transitory should begin correcting themselves. But as we know, things shift and change quickly and we have to be prepared for anything.
Historically value stocks have outperformed growth in inflationary environments. We’ve seen some of that play out this year, especially in the smaller company stocks. Certainly some of the high-flying growth names from last year like Zoom, Peloton, Zillow, Teladoc, etc. have been hit hard, but the Russell 1000 Growth Index has outperformed the Russell 1000 Value index of larger companies despite sectors like Energy and Financials having relatively strong years. Sector leadership has shifted significantly over the year as Energy, Utilities, Real Estate, Materials, Technology, Health Care, and Financials have all had monthly top-performer status this year. A big difference from the last several years where Technology would often dominate. This is good for well-diversified portfolios, but more difficult for those trying to guess on momentum.
We can’t look at anything in a vacuum when it comes to markets or stock performance. Inflation is obviously a big focus and one that will continue to be monitored in terms of how high it remains for how long. The longer it persists high, the lower the short-term outlook would be, but as of now stocks still remain the most attractive investment option for investors. Some of the other reasons are still being on the earlier side of the typical length of a bull market, the wide range of sectors that have shown leadership (as discussed above), continued strong consumer spending helping companies to continue to beat Earning per Share and Revenue Estimates at higher than expected levels, and the fact that we have been seeing things mostly hold up even with the headwinds of inflation, labor shortages, and supply chain issues factored in to prices.
To be fair, not everything is rosy at this point, and while I (and most market watchers I follow) remain overweight to stocks compared to other asset classes, there are plenty of headwinds in addition to inflation that could lead to underperformance from stocks in the short to mid-term. Valuations such as price to sales or Warren Buffett’s favorite US Stock Market Cap to GDP ratio remain near record highs, the potential for COVID related restrictions as we go into the winter months especially with Omicron now being the new “scary” version to impact travel and leisure stocks (and maybe more), the fact that the 2nd year of presidential cycles has historically been the worst and we have plenty of uncertainty and drama in Washington, potential fiscal drag on GDP from all of the stimulus, and the potential for the Fed to communicate or execute poorly when it comes to future interest rate increases.
Sorry for the long manifesto. Just so many things that I wanted to pull together related to things I’ve read over the last several months that I’ve been sharing with clients who’ve been asking. What I’ve realized is that it’s one thing to understand the textbook definitions and theories of what should happen, but in an interconnected world with so many moving parts it is important to stay flexible and expect the unexpected and be willing to adjust accordingly. The enduring principles of investing of primarily remaining invested, being diversified, embracing risk (to the level of your comfort and situation) through owning shares of great companies who are providing valuable goods and services, keeping costs reasonable, and continuing to invest new money whenever you are able to do so remain the most important principles for us to follow. The rest of it we navigate along the way.
Disclosures: The market indexes discussed are unmanaged and generally considered representative of their respective markets. Individuals cannot directly invest in unmanaged indexes. Past performance does not guarantee future results. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. Diversification does not guarantee profit nor is it guaranteed to protect assets. Investors should be aware that investing based upon a strategy or strategies does not assure a profit or guarantee against loss.