Do you remember when the Fed was desperately seeking to boost inflation to a ‘healthy norm’ of 2%? Achieving that goal was Janet Yellen’s mission for years. Thanks to a confluence of factors—including money printing, deficit spending, global supply chain disruptions, and a post-pandemic consumer buying frenzy (even if the pandemic appears to be far from over)—that goal has finally been achieved. Inflation has officially taken off. Instead of the Fed fretting over how to battle extremely low inflation with interest rate reductions and other strategies, all eyes are now on how to rein in inflation which many fear is poised to spiral out of control. For investors, that shift begs the question: ‘How does inflation impact my portfolio?’ And more importantly: ‘Do I need to adjust my investment strategy to address the current environment?’

Before we dive in to the impact of inflation on your portfolio and your strategy moving forward, let’s take a brief look at inflation basics: 

• What is inflation?
  Inflation, by definition, is ‘the decline of a given currency over time.’ This decline is driven by fluctuations in consumer prices year over year. For example, when the Fed reports that inflation is at 4%, that means that prices have increased by 4% compared to the prior year—and that every dollar you earn will buy approximately 4% less than it did just one year ago. The Fed considers 2%-3% inflation to be the marker for a healthy economy and an indication of steady economic growth.

• How is inflation trending today?
  Inflation is accelerating. The current annual inflation rate for the 12 months ending in July 2021 is 5.37%-—more than double the Fed’s 2% target. Here in California, inflation is trending slightly lower at ~4% year over year. Considering that inflation was running well under 2% for the past 10 years, this increase can sound like a shock, but a little history can put the numbers into perspective. Like the stock market, inflation tends to revert to the mean, which reduces today’s increase to a mere blip on the radar:

  

• Is inflation as bad as the headlines portend?
  In short, no. The inflation numbers are undeniable, but inflation itself isn’t a bad thing. That’s why the Fed has been focused on battling deflation for the past decade. Deflation occurs when the price level of goods and services declines. While it’s easy to view deflation as a good thing because it gives consumers greater dollar-for-dollar purchasing power, lower prices can have a negative impact on key sectors of the economy. Deflation is particularly damaging to borrowers who are forced to pay off existing debt with dollars that are worth less today than it was when they took out a loan (including borrowing money on a credit card). In contrast, inflation and the related increase in the Consumer Price Index (CPI) reflect a growing economy. As you can see in the following chart, historically, consumer prices rise at a relatively steady rate over time as the economy grows:

  

  A healthy economy and moderate inflation are good for investors, largely because this means the companies you are invested in are growing. The problem comes when inflation is sustained over a long period of time.

  Unfortunately, if sustained, rising inflation can be problematic for investors. According to this recent article in Forbes, “the classic 60/40 stock/bond portfolio may get hit from both sides, as prices rise both stocks and bonds can fall in price. In fact, a 60/40 strategy has historically returned around 9% a year, but closer to 2% during high inflation.” It is important to remember, however, that the CPI fell dramatically in 2020 due to the pandemic. As illustrated above, the pickup in inflation has simply brought inflation back to the trend line.[1]

• So… is it time to rethink my investment strategy?
  Probably not. First, from the Fed’s perspective, the current hike in year-over-year inflation is likely to be transitory. Cyclical sectors (such as recreation, housing, and food services) are driving the majority of the rise in prices today, which makes it likely that these sectors will cycle down again within 12 months or so. Also, as the pandemic eases and global supply chains accelerate, bottlenecks will be removed and production will increase to create deflation. Lastly, much of the rapid increase in inflation is rooted in price increases in isolated sectors, including oil and housing. When these two sectors are removed from the equation, the CPI may well be on or even below trend.

  While inflation is commonly considered bad news for stocks, this is usually true only in the short term. Over the long term, stocks can be strong inflation hedges, and allocating to stocks often generates returns that exceed the pace of inflation. On another positive note, in many previous periods of high inflation, the market fluctuated in response to the Fed’s reaction (or expected reaction) to inflation with changes in interest rates. This time around, the Fed is openly communicating its willingness to be patient with inflation rather than acting too quickly in an attempt to achieve the target long-term rate of 2%. But the Fed is not sitting idle. At the July Federal Reserve Meeting, plans were made to pull back monthly bond purchases, likely before the end of the year. Will that tapering be enough to make a difference? Will the Fed be too patient and allow price levels to jump too high? Will such a jump demand a sharp rise in interest rates? Only the future will tell.

 From our perspective, we expect the recent inflation figures to have very little impact on most investors’ investment strategies and allocations. We strongly believe that the best protection against inflation is a well-diversified portfolio. That said, we have no crystal ball and, like the Fed, we aren’t sitting idle. We are keeping our eyes on the numbers, analyzing long-term inflation projections, and adjusting our portfolios as necessary to help preserve your purchasing power, your portfolio, and your long-term wealth.

Still concerned about the potential risk of inflation? Please call or email us to schedule a conversation.

[1] While inflation is often quoted in a year-over-year growth rate, this graph illustrates the absolute price level to illustrate the point. The trend line is estimated by regressing the preceding 5 years of CPI data before the Covid-19 pandemic.

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