By Tim Courtney, Chief Investment Officer
Oil is back above $60 a barrel.1 The dollar has fallen about 12% against foreign currencies over the last year.2 Home price offers are getting larger3 and food packaging is getting smaller.4 Are we seeing a resurgence in inflation?
Our government and institutions have decided that a certain level of inflation (the Federal Reserve targets 2%5) is preferable to deflation. This is partly because in deflation, most asset and commodity prices fall, which discourages investing and spending and encourages cash hoarding for later use at lower prices.6 It also makes paying back debt – something Americans have a lot of – much more difficult.
Since 1926, Consumer Price Index inflation has averaged 2.86% annually and excluding the deep deflation of the early 1930s, has averaged 3.54%.7 Inflation has been very tame recently with a 1.74% average over the last decade, below the Fed’s 2% target.7 This low inflation, coupled with low interest rates, was a near-perfect environment for stocks, bonds and a “Goldilocks economy.”8
Many are wondering if inflation is going to start moving higher and closer to its long-term average. Deferred consumption, recovering demand and a large increase in our money supply have markets concerned that inflation is coming.
Some signals suggest inflation is rising
Fed actions in 2020 increased our M2 money supply by nearly 25%, a record increase.9 At the same time, the U.S. government has maintained high levels of spending through stimulus checks to citizens and Paycheck Protection Program (PPP) loans for small businesses. The Producer Price Index, a measure for changes in prices producers receive for selling their products, was up 1.3% in January – the largest monthly increase recorded for this data series.10
As investors have become more concerned about inflation, they have pushed up the prices for assets linked to inflation, such as Treasury Inflation-Protected Securities (TIPS).11 These bond prices now reflect an expected inflation rate higher than 2%, aligning with the Fed’s new policy of allowing inflation to run ahead of target for now.12
There are some mitigating factors that will limit inflation
Some believe we will be stuck in a low inflationary environment for some time because of the damage done to the global economy, technological efficiencies helping to keep prices lower and the fact that much of the created money has been saved and held on bank balance sheets, not spent or loaned. Some businesses are still struggling, and many households remain behind on their rent and mortgage payments.13 Also, the U.S. dollar, which if weakened would likely lead to inflation, has been holding steady over the last three months.14
How do we protect portfolios?
Inflation silently eats away a portion of investor returns, and we do believe that increasing inflation is a risk. This has already affected markets and is partly responsible for some of the recent market volatility.15 If inflation stays near its 100-year average, we think typical stock and bond portfolios should be resilient. Interest rates on bonds are rising and increasing future expected returns to help investors account for inflation. Stocks should hedge normal inflation through increased cash flows coming from higher consumer prices.
History does show though that when inflation begins a multi-year move above its long-term average, close to 4% or more, there is added pressure on stocks and bonds. We are not near this level of inflation yet. However, if more signs confirm much higher inflation, there are investment tools to utilize in portfolios such as increased weights to real assets16 (real estate, commodities, gold) and certain stock sectors that are better inflation hedges.
We believe investors today are still best positioned by maintaining a diversified portfolio of equities. We continue to watch for inflation signals. Please contact your Exencial advisor if you have any questions.
Sources:
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
The Producer Price Index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indices that calculates and represents the average movement in selling prices from domestic production over time. The PPI measures price movements from the seller’s point of view. Conversely, the consumer price index (CPI) measures cost changes from the viewpoint of the consumer. In other words, this index tracks change to the cost of production. There are three areas of PPI classification that use the same pool of data from the Bureau of Labor Statistics: industry, commodity, and commodity-based final and intermediate demand (FD-ID).
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