You’ve probably heard about inflation recently. It’s been hard to miss if you read the newspapers or turn on your TV. Heck, I pass a billboard on my way to work advocating I buy silver to protect against inflation. This begs the questions, is there a real risk of inflation? Is it something to worry about? What can we do about it?
As the chart below shows, there is no doubt that we have seen inflation rise since the recovery from the short COVID induced recession in 2020. The current level of 4.99% is the highest we have seen since September 2008.
What is less clear is whether this uptick in inflation is a short-term issue caused by pandemic related supply chain disruptions, the beginning of a long-term period of rising prices caused by excessive government spending and debt levels, or something else entirely. For one, I think it’s too soon to tell, and if you follow this blog, you know we are not in the business of predicting the future.
However, we can take a closer look at the current environment, explore what the Fed might do in an attempt to control sustained rising inflation, and most importantly understand the benefits of a well-diversified portfolio in protecting against rising inflation.
First off, I think it’s important to recognize that many of the headlines and numbers we see today are skewed due to the impact of COVID. Take this chart below for example, it shows the consumer price index for apparel from 1988 – present. The drop in demand during the COVID lockdown drove prices down to levels not seen since 1988! Despite a strong recovery, prices are still well below the long-term average. Many other parts of the economy that were negatively impacted by the lockdowns in 2020 tell a similar story. Any number reported as year over year percentage needs to be taken in context of where we were a year ago and how it compares to longer term data.
It’s also worth noting that we have seen many periods of rising inflation before. The next chart from July 2009 – December 2009 shows an increase similar to what we’ve seen over the last year. The inflation rate quickly jumped from -2.10% to 2.72% in just 5 months.
Part of what makes the current increase shocking to people is that it has been so long since we have seen a sustained period of above average inflation. However, that too has happened before. Here is a chart showing the inflation rate from July 1955 to April 1980.
After this peak inflation rate in 1980, we’ve experienced 40+ years of a declining, or low inflationary environment. We’ve seen below average inflation for most of the past 10 years.
Again, we may see inflation cool off once the issues from COVID lockdowns have more time to sort themselves out. If that’s not the case, The Federal Reserve has a variety of tools at their disposal to manage increasing inflation over a longer time frame. One of these tools is to increase interest rates. The theory is that as interest rates increase, people borrow less money, which leads to less spending, and cools rising prices and inflation. It is also thought that this will slow the economy and generally have a negative impact on the stock market. In its April meeting, The Fed maintained their current low interest rates and gave no signs of increasing them in the short-term.
So, what does this all mean exactly and what can you do about it from an investing standpoint? We expect some asset classes to perform better than others in a rising interest rate environment. A well-diversified portfolio, owning the asset classes below will provide protection against inflation and the negative impact it may have on domestic stocks and long-term bonds.
- Short-term bonds –short-term bonds don’t decline as much as long-term bonds during periods of rising rates. This is because the short-term bonds mature and can be reinvested more quickly at the current and higher rates.
- International Stocks / Global companies – other economies around the world may not be experiencing inflation at the same time we are at home, therefore those companies and international stock markets in general may perform better. In addition, global companies with a large portion of business overseas may tend to perform better because less of their business will be impacted by the inflationary pressure on the US Dollar.
- Real Estate – real estate assets either as REITs in your portfolio, or that you own outright, offer a good hedge against inflation. Tangible asset prices and rents increase as prices move up benefiting the owners. If your mortgage is locked in at a low long-term rate you will benefit by earning a higher rate on your savings and paying off the debt with a depreciated dollar.
At TAAG we know markets and the economy will go through periods of turmoil for all sorts of reasons. Rising interest rates and above average inflation is certainly one of the possible scenarios that could play out in the future. We know we can’t predict exactly what will happen and when. However, we don’t need to, by maintaining a well-diversified portfolio we are positioned to capture the positive returns no matter what asset class produces them.