After many years of relatively stable prices, the sudden return of inflation in the U.S. became a key market theme in 2021. The latest Consumer Price Index data released on February 10, which showed that the annual rate of inflation reached 7.5% in January, indicated that it will likely remain a big story this year, as well. With no sign yet of easing price pressures, investors are wondering if this is a “new normal,” or if high inflation will prove to be transitory. They are also asking if changes should be made in their portfolios to reflect a potentially higher inflation environment. Before addressing that question, I think it’s important to review how we arrived at this point in the inflation cycle.
The government’s response to the COVID-19 pandemic
Recall that as the pandemic was unfolding in March 2020, most schools, restaurants, movie theaters, sports arenas, and public transportation systems began shutting down in rapid succession. Millions of Americans were suddenly thrown out of work, and the economy quickly fell into a deep recession. The 35% decline in U.S. stocks (from all-time highs the previous month) was also the fastest ever. In response to the historic health and economic crisis, Congress passed a series of major stimulus and relief packages amounting to nearly $5.9 trillion dollars over 18 months, equivalent to more than 25% of annual GDP. The packages included enhanced jobless claims benefits, small business loans, an eviction moratorium, enhanced child tax credits, and direct stimulus payments to taxpayers. All combined, the size of these new programs was vastly greater than the response to the Global Financial Crisis in 2008-09.
The unprecedented levels of government support were a boon to consumer finances and enabled newly unemployed people to remain in their homes and continue spending. The packages were largely paid for through deficit spending (new borrowing). Concerned that natural investor demand for U.S. Treasuries would be insufficient to absorb the high level of new bond issuance required, the U.S. government implemented a version of “wartime finance.” This meant that the Federal Reserve would work in tandem with the U.S. Treasury to ensure that this additional borrowing would be financed at very low rates of interest, despite its enormous size, similar to steps taken during and just after WWII.
Supply chain problems
Consumer behavior also changed during this period, shifting toward goods purchases and away from services. This trend put additional strain on existing supply chains, causing shortages and delays in some products, which led to higher prices. Weather disruptions, Covid-related restrictions (testing, sporadic shutdowns) and missing workers (due to early retirements, illness, job changes, or leaving the workforce to care for dependents) added to supply chain issues, leading to higher wages for the workers that remained, and higher prices on products in high demand. Energy prices surged, as well, impacting food prices and other products that must be transported over long distances. The combined effect of these developments was straight out of economics textbooks: lower supply + greater demand = higher prices.
Permanent or transitory?
The outlook for inflation over the next several months remains uncertain and we believe will depend largely on how the Covid pandemic evolves from here, but there are reasons to expect that inflation will decline to more tolerable levels before too long. First, none of the conditions that led to today’s high inflation are likely to be permanent; supply chain issues should resolve eventually, and workers, enticed by higher pay, should re-join the workforce. Secondly, there are no additional fiscal stimulus packages on the horizon, and excess levels of consumer savings have normalized. Third, the Federal Reserve has telegraphed an imminent tightening in monetary policy, including the end of quantitative easing (asset purchases) and increases in short-term interest rates, beginning next month. Fourth, market-based measures of long-term inflation expectations are still well anchored at around 2.6%. Finally, we still inhabit a structurally deflationary world, with demographic trends, technological disruption, and high levels of debt, all acting to subdue inflation in the long run.
How should investors react?
Before making any changes to one’s investment portfolio, it is always a good idea to first identify the goal. For example, are you trying to hedge inflation, or outpace it? There are financial instruments available to hedge unexpected inflation (e.g. Treasury Inflation-Protected Securities), if that is your goal. However, most investors should probably be more focused on increasing their purchasing power over time, which means earning positive real (inflation-adjusted) returns. With respect to that measure, how did the major asset classes perform last year in a higher inflation environment?
Recall that inflation came in at 7.5% last year. In general, bonds did not have a good year in 2021; a diversified basket of government and corporate bonds was down by about 2% in nominal terms. After inflation, the average bond fell by nearly 10%.
Gold performed even worse, falling by 3.6% in 2021 before adjusting for inflation. Note that gold has not proven to be an effective hedge against inflation in the short term, but has outpaced inflation in the long term.
Treasury Inflation-Protected Securities (TIPS) did better than bonds and gold, gaining 5.7% last year, but still declined in real (inflation-adjusted) terms because interest rates rose in 2021, along with inflation. TIPS protect holders only against the latter.
How about stocks? As an asset class, global equities produced strong returns in 2021. The Vanguard Total World Stock ETF, a market-cap weighted index fund representing a diversified basket of global equities, rose by 18% last year. Stock market investors not only kept up with inflation in 2021, they outpaced it significantly.
Now, I don’t mean to suggest that stocks always outperform inflation; in fact, there are many years in which this is not the case. Investors should know that stock returns are volatile, and markets are prone to large and small corrections, including “bear markets” that can last for years. While we can’t predict what stock returns or inflation may do in any given year, we do know that no other asset class has the same track record of positive inflation-beating returns over the very long run. As shown in the following chart, inflation has eroded the value of the U.S. dollar by a factor of 15 since 1926. In comparison, U.S. large stocks have grown by nearly 11,000 times in the same timeframe.
Investors in the United States have not had to worry much about rapidly rising prices for a long time. While surprising, the return of inflation last year serves as an important reminder that the main goal of an investment portfolio is to grow your purchasing power over time. In other words, a well-designed portfolio should earn positive, inflation-beating returns in the long run. For more than a century, stocks have proven very effective at this goal and have been the main driver of returns in a diversified portfolio. Radically changing your investment allocation in response to recent inflation statistics may not only be unnecessary but counterproductive, as well. By simply maintaining a sufficient exposure to U.S. and international equities, investors may be better prepared for inflation than they realize.
Disclosure: The opinions expressed herein are those of Elevate Wealth Advisory (“EWA”) and are subject to change without notice. EWA reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product. EWA is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about EWA, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.