So, what is the "big deal" with inflation currently?
Paul Tarins, RICP®,WMCP®,CSRIC™
We have all experienced prices for goods and services rising over time as the economy and money supply expand. Whether it is the price of a can of pop, or a ticket to the movies, we each have our own personal barometer of inflation over the course of our lifetime. You may have noticed that inflation has found its way back into the headlines again - this time in the guise of a stock market “boogie man.” In this article, we revisit drivers of inflation and why it is so important to both markets and your future financial welfare.
For those senior enough to recall, the late 1970s and early 1980s featured inflation in the low double digits, peaking at 14.8% in March 1980 (Federal Reserve Economic Database). To break the cycle, then Federal Reserve Chair Paul Volcker famously tightened monetary policy to extremes by raising lending rates to 20%. That forced a three-year recession that "broke the back of inflation." Since that storied time, inflation has fallen to the low single digits supported by globalization and technology-driven productivity improvements. The events that lead to the prior spat of inflation were complex, but suffice to say that government regulation played a significant role at both the fiscal and monetary levels. The lesson of potential policy missteps has carried forward ever since, which is what markets fear most. The type of inflation markets prefer is gentle and demand driven as economies naturally grow in step with population and Gross Domestic Product ('GDP').
So, what is the "big deal" with inflation currently?
While inflation is relatively low at the moment (4.2% for the 12 months ended April 2021, according to the Bureau of Labor Statistics), it has risen sharply lately and there are strong concerns that the economic surge in reopening from Covid is causing materials and supply constraints at a time when labor is also hard to come by, and while our federal banks and politicians continue to practice "Modern Monetary/Fiscal Policy," effectively placing extreme stimulus measures above prudence with easy money and government spending.
As a percentage of GDP, Covid-responsive fiscal stimulus represented over a quarter of our economy last year (Statista), all while the Federal Reserve Bank simultaneously adopted a zero-interest rate policy. The Federal Reserve has intimated it will continue with its easy money policies until we see stronger re-employment, perhaps another year out, while the Biden Administration is lobbying for a $1.9T multi-year infrastructure bill. The natural fear is that the combination of real growth, supply constraints, and possible policy errors respecting the foregoing will together lead to even greater inflation in the months ahead. And when it comes to markets, the fear of inflation is as important as the actual event itself.
Having established potential levers for future inflation, we next ask why this is all so important to markets. First, there is the problem with bonds. When interest rates rise, as they have this year, the value of bonds fall. Why? Existing issues feature lower rates. To keep parity with new issuances set at higher rates, the only way for investors to compensate for lower future payments is to pay less upfront for bonds when they transact. This represents what we call "duration risk," where longer-dated bonds face ever steeper compensating discounts. Stocks face a similar time-based problem. Like bonds, their value derives from future expectations of earnings and growth. Somewhat akin to an interest rate, investors calculate the current value of those earnings using a "discount rate," which incorporates future inflation expectations. Higher interest rate expectations translate to higher discount rates and lower current valuations. For growth companies where investors expect most of a firm’s value to derive from future earnings, the subsequent repricing can be especially painful. This is exactly what we have seen this year, with growth stocks significantly underperforming value stocks buffered by higher current earnings.
Thus, inflation expectations directly impact the value of stocks and bonds alike; and so, the debate over the future level of inflation, and whether it is temporary or permanent has played a significant role of late in the daily gyrations of the market. The Federal Reserve has stated its belief that inflation will be “transitory,” but it will really come down to wage growth ahead, which tends to be stickier. Of course, only time will tell how this all plays out. While interest rates have stabilized for the moment, we tend to think they have higher to go before they renormalize to levels expected in a post-pandemic world. That is to say we may see further stock and bond repricing and/or periodic volatility ahead. However, there is an especially important kernel of good news hiding in owning stocks and bonds in the long-run, and that is how we will finish our discussion below.
We began this article referencing personal barometers of inflation. Something costing a dollar in 1960 likely costs $8.86 today (InflationTool.com). Conversely, a dollar left sitting in your wallet since 1960 is only worth about 12 cents today. Even from just the year 2000, a dollar is only worth 65 cents today. The devasting toll inflation can take on our savings is clear, and the implication for our retirement accounts is a critical take-away. The magic bullet we thankfully have, is investing. Short-term effects aside, in the long-run companies have the ability to raise prices alongside inflation. Bonds also eventually rollover and reset into higher yields. All in all, participation in markets thus allows our savings to keep pace with inflation and then some over time, and that is ultimately what investing is all about.
Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics, a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated.
