Although investors and analysts continue to focus on the relentless climb of the stock market and proffering their two cents on its near-term direction, the 800-pound gorilla in the room is starting to beat its chest and becoming more difficult to ignore. For the most part, the prospect of any surge in inflation has been dismissed by economists and monetarists as an economic outlier that can be controlled. Tell that to consumers at the gas pump or grocery store where prices have been steadily rising for the last month.

Except for, perhaps, the baby boom generation, most people alive today have never experienced a sustained period of rising inflation. Since the 1980’s the rate of inflation has been on a slow, albeit bumpy descent, and it has been virtually nonexistent over the last decade, averaging less than 1.5%. 

Then, in April 2021, inflation appeared to turn on a dime, posting its highest year-over-year increase in decades. The media has been fixated on this surge, and economists are sounding the alarm over government policies that seem certain to unleash it further. The widespread consensus is that inflation looms large on the horizon if it hasn’t already arrived.  

Or not, according to many economists who insist that we are still in a low-inflation economy and that these spikes in inflation are transitory or outliers. Who is right, and should investors be worried about the return to an inflationary environment? 

Do We Even Know How to Measure Inflation?

The signs would appear to be irrefutable. Spiking commodity prices surely must be the result of inflationary pressures that were predicted following the massive injection of money into the economy to stave off the pandemic-induced economic downturn. 

Historically, it has been almost a direct cause and effect scenario in which stimulative fiscal and monetary policies increase the inflation rate, so why would it be different this time?

This ambiguity stems from the lack of conformity in understanding what inflation is and how it manifests itself in the economy. And ever since the government decided to remove food and energy goods from the CPI basket, even the measure of actual inflation is open to interpretation. So, not only are we not sure what is being measured, we can’t be sure if it is being measured correctly.

The Two Faces of Inflation

Our high school textbooks teach us that inflation results from too many dollars chasing too few goods. In other words, in a growing economy, increasing consumer spending pushes demand up to where it exceeds supply which drives up prices. 

Modern inflation, if there is such a term, is more a creature of the money supply which, before the complete decoupling of the dollar from gold, wasn’t much of an issue (although money supply manipulation goes way back to the creation of the Federal Reserve in the early 20th century). Sticking with the fundamental principle of “too many dollars chasing too few goods,” a sharp increase in the money supply by the Fed can trigger inflation, but in a different way as we have seen just recently. 

Where Has Inflation Been the Last Five Years?

In its quixotic effort to stave off deflation, the Fed flooded the financial system with hundreds of billions of cheap (low-interest rate) dollars. Those dollars have to go somewhere, but instead of finding their way into consumer prices, they found their way into the stock market, where they inflated asset prices resulting in the steepest stock market rally in history. The Fed was actually off target because it had expected the dollars to find their way into the crashing real estate market via the banks. But instead, institutions and big investors snatched up the cheap dollars and poured them into stocks. The result would have been the same either way: Asset inflation.

Because inflation is being funneled into asset prices, we have yet to see a significant increase in consumer prices. This has allowed interest rates to remain low, and that, in and of itself, is a boon to stocks. Lower interest rates can increase the value of stocks because it makes discounted future cash flow more attractive to investors. 

The Impact of Inflation on Investments

While this explanation of recent inflation may make the case that it doesn’t necessarily have a negative impact on equities, there is plenty of evidence to show that it can. But the only real correlation found to exist between stocks and inflation is that stock valuations improve at the first signs of declining inflation and fall when it initially appears. This can be attributed to investor concerns over discounted future earnings. A company’s PE multiple will have less value when future earnings lose their purchasing power. 

Generally, stocks have performed well against inflation. Over the last 30 years, U.S. stock prices tend to rise when inflation accelerated, though that relationship is somewhat tenuous. Producers are able to increase prices in response to the increased demand, at least to the point when demand begins to fall. This can drive earnings growth in companies that can increase production without increasing its cost.

In periods of sustained inflation, the cost of production can also rise due to the increased cost of labor and material, but much of that increase can be passed on to consumers. In a normal economy, this type of inflation, especially if it is moderate and steady, can be good for stocks. 

This correlation is stronger with larger companies with strong brands and competitive positions because they can increase prices. That means their revenues and earnings should increase at the same rate as inflation. Mid-sized companies have a weaker relationship with inflation, but it’s stronger than smaller companies. 

Equities are productive assets that have, on a total return basis over time, provided a steady hedge against inflation. However, in times of sustained or severe inflation, deflation or hyperinflation, all bets are off.

Fixed Income Investments

Assets such as fixed-income investments with fixed, long-term cash flows generally don’t perform well in inflationary environments. That’s because inflation erodes the purchasing power of future cash flows over time. As a result, the price of fixed-income investments tend to decrease when the inflation rate increases. In that environment, bond yields rise, causing bond prices to decrease. However, it also creates the opportunity for fixed-income investors to purchase higher-yielding bonds which can generate more income for their portfolios.

Investment-grade longer-term bonds are impacted more than shorter-term bonds due to the cumulative effect of eroding purchasing power for cash flows long into the future. Low-rated high-yield bonds are less affected because of their higher interest payouts. 

One exception would be Treasury Inflation-Protected Securities (TIPS) issued by the U.S. government. The rate on TIPS is adjusted according to the CPI, resulting in a more stable performance than other fixed-income assets. 

Real Assets

Historically, commodities and real estate have had a mostly positive relationship with inflation. Commodities, including oil and industrial and precious metals, are natural inflation eaters, rising almost in tandem with inflation. However, historically, commodities have underperformed stocks and bonds, and they tend to be more volatile than other asset classes because they don’t produce income. 

Investment in rental properties is a sound hedge against inflation because landlords can increase rent payments to keep pace with the rate of inflation. 

Effect of Inflation on Interest Rates

Interest rates are especially sensitive to rising inflation. When inflation expectations increase, the Fed applies the brakes by increasing short-term rates. This increases borrowing costs, leading to less money to spend on goods and services, which ultimately tightens the money supply (money in circulation). The objective is to reduce the demand that is fueling inflation.  

Until recently, the Fed hasn’t been too concerned over rising inflation, stating in January 2021 that it is still targeting 2% inflation with no plans to increase rates in the foreseeable future. That could change should the economy continue to heat up, leading to higher interest rates later this year. 

Effect of Inflation on Purchasing Power

One thing we know for certain about the cause and effect of inflation is its impact on your purchasing power. When the inflation rate exceeds the growth of your money, it erodes at your future purchasing power. For periods of sustained, high inflation, the impact can not only lead to reduced purchasing power, but it can also reduce the amount of income available in the future. That’s why it’s essential to maintain exposure to equities long into retirement.

Positive Effects of Inflation

Currently, the Fed is targeting an annual inflation rate of 2%. Its thinking is that allowing price levels to increase slowly will help businesses stay profitable while encouraging consumers not to wait for lower prices before making purchases. More importantly, moderate inflation can help to reduce the risk of deflation. 

Rising prices resulting from mild inflation motivate consumers to buy now to avoid paying higher prices later. This results in a short-term increase in demand, leading to increased retail sales and the production of goods and hiring more workers to meet demand. The net effect is a boost in economic growth.

The other reason why mild inflation can be a good thing is it reduces the risk of deflation—or falling prices—which can be more devastating than inflation. When prices fall, consumers hold off on purchases if they think prices will fall further. That reduces demand causing businesses to reduce their inventory and factories to cut back on production. That leads to rising unemployment, wage deflation, and reduced consumer spending. Demand decreases even more, and businesses reduce prices further, exacerbating deflation and creating a vicious cycle that is difficult to reverse. 

Impact of Inflation on Portfolio Decisions

Temporary spikes in inflation are not likely to have a significant, long-term impact on your portfolio. However, a sustained inflationary environment could wreak havoc on your portfolio over time. Working with your financial advisor, you can fortify your portfolio against the negative impact of inflation. Here are some steps to consider to inflation-proof your portfolio.

While you can’t control when or if inflation will strike again, you can take actions that will protect your portfolio against its effects. We invite you to meet with an advisor from Dechtman Wealth Management for a free, no-obligation portfolio review.