SHOULD WE GET CRAZY ABOUT INFLATION?

How much fun would it be to get paid for making bold predictions, and then never be held accountable when we’re wrong?

If we really want to know the answer, we should be asking the talking heads on TV and online – the financial pundits whose job it is to make headlines by saying something, anything, provocative.

I get it: predictions by nature leave room for error. But many people take predictions as certainty and act accordingly. And how many times do the fact-checkers go back to determine if those predictions were correct? Almost never.

That’s how the pundits are approaching the issue of whether inflation is now on the horizon – they’re making a storm of big predictions.  But I’m not here to bet the house for or against the likelihood and impact of inflation.  I’m here to demonstrate that there are many pieces to the inflation puzzle, and that no one knows for sure if we will experience it, whether it will be sustained or short-lived, and how the markets will react.

All of that is still unknown, and anyone claiming to be certain of their position is misleading you.

Why, by the way, should we care about inflation in relation to the markets? Because increased inflation reduces the value of companies’ future cash flows and thus earnings, meaning that the price you are willing to pay today for those companies is also reduced – which typically hurts companies that have high valuations based on strong growth prospects.

Second, rising inflation means higher prices, which could cause the US Federal Reserve to raise interest rates in a bid to prevent the economy from overheating and inflation from getting out of control. Higher interest rates are again potentially negative for company earnings and economic activity.

At time of writing, we are experiencing a red-hot real estate market, rising energy prices, copper hitting record prices, lumber up 50% this month, crude oil hitting its highest levels since 2018, soybean skyrocketing, and new car prices continuing to rise. As well, manufacturing and services activity in both the United States and United Kingdom not only rose compared to April, but hit their highest combined level in any month – ever.

Combine all of that with about $2-trillion in excess savings by consumers just waiting to spend (i.e. pent-up demand), plus continued accommodative monetary and fiscal policy, and one can easily make the argument that we will see soaring inflation.

On the other hand, you could say these are the same fears that existed after 2008:  that inflation would run rampant after unprecedented spending. But that never happened. In fact, inflation has remained relatively low for the past 20 years.

I think it’s a safe assumption that we will experience some near-term inflation at least in specific sectors. It is happening already and will continue once we can all start spending.

That said, we should ask whether the inflation we are seeing is simply coming from the supply chain and bottleneck issues that have arisen as a result of the pandemic – rather than because of increased demand that will go away once world economies return to 100% capacity. Examples of this potential phenomenon include the current lumber shortage, global computer chip shortage and labour force shortage, to name a few.

The most important question is whether we will see sustained, long-term inflation versus something that is simply transitory – because that’s the question the US Federal Reserve really cares about. Here is a statement from Fed chief Jerome Powell from March of this year: “If we do see what we believe is likely a transitory rise in inflation, I expect that we will be patient [in raising interest rates]. There’s a difference between a one-time surge in prices and ongoing inflation.”  In fact, the Fed has been adamant that inflation will be transitory and fade by 2022. 

THERE IS NO CRYSTAL BALL

The bottom line is that no one has a crystal ball. Trying to make parallels to “similar” times in history, 2008 or otherwise, isn’t a perfect science, because we really are in uncharted territory.

We could draw all kinds of comparisons, including: Covid to a natural disaster like the 2011 Japanese tsunami and earthquake (a comparison many experts have made); current government spending to WWII spending; potential inflation to 1970s soaring inflation; potential transitory inflation to the late 1940’s and early 1950s, when we saw a short-term inflation spike.

The fact of the matter, however, is that today’s environment is simply not the same for three big reasons. First, the recession we just came through was one of the shortest in history, in which a segment of the population actually improved their financial position. Second, we have an unprecedented accommodative fiscal and monetary policy against a backdrop of strong growth and the beginning of an economic expansion. And third, Fed policy today is like nothing we have ever seen: for the first time, it has changed its policy in order to let the economy run hot, so it can achieve sustained inflation above the 2% target and also maximum employment.

WHAT IF WE DO EXPERIENCE INFLATION?

If we do experience inflation, it means we are on the other side of the pandemic. It means that wages are rising, people are spending and the economy is running hot – so it’s really not the worst thing in the world.

Second and more importantly, it means we’ve avoided a much bigger risk, deflation: a world of decreased spending, lower incomes and higher unemployment. This is one of the reasons for the new Fed policy – to avoid deflation. We’ve seen high inflation in the past and therefore have tools to handle it – versus deflation, which we have not seen in a long time.

As well, following the 2008 crisis, we saw almost no inflation, although we had accommodative monetary policy, which led to what? Subpar economic growth and wealth inequality. Therefore a sustained period of inflation would lead to wage growth, which would likely benefit lower income workers (Goldman Sachs recently showed that wage growth is accelerating for lower income workers, another positive about inflation). This is the second but equally important objective of the Fed policy change: maximum employment, a more inclusive goal in hopes of benefiting low- and moderate-income communities.

So it’s possible that inflation, if we do see it, may not be the worst outcome in the world – but time will tell.

SHOULD THIS MATTER TO YOU?

Yes, it’s important to be mindful of inflation but it doesn’t come close to meaning we should drop our current process and overhaul your portfolio. Remember, making predictions and building a pension-style portfolio are two very different things. By making big bets on where the market will be, there’s always a possibility of getting it wrong, which could be detrimental to your long-term objectives. It’s about staying true to our disciplined investment philosophy and process combined with using the various tools and strategies to adjust, prepare and protect should we experience a sustained inflationary environment.  It starts with building a diversified portfolio not only by geography but by sector, by asset class and even by style – value vs. growth, for example.

From there, we make tactical adjustments to ensure you’re prepared and we hedge the potential risks – not taking a gamble on one side or the other, because if we’re wrong, we could derail your investment goals.

In a world that may see rising inflation, let’s remember that equities are an inherent hedge against inflation given that their objective is to maintain purchasing power.  Secondly, it’s important to have exposure to real estate, gold, commodities and energy. Many of these sectors perform well in a rising inflationary environment. Ultimately you want to ensure you have exposure to cyclical sectors that will perform well as the world opens.

But if inflation turns out to be in fact temporary, the current volatility in growth stocks could turn out to be a buying opportunity – which is why it’s important to build a portfolio with the multiple styles I just mentioned above.

Trends come and go, styles will move in and out of favour, and market forces will continue to change, as they always do. New risks, both micro and macro, will present themselves – as they always do. Inflationary pressure is just another potential fear that will likely continue for the foreseeable future. It is something we’ve seen in the past, and therefore we have the tools and strategies to manage it.

The most important takeaway is that you shouldn’t try to chase new trades in an attempt to time the market. More likely than not, you will get the timing wrong – and it’s a certainty that you will significantly increase the risk of your portfolio.

It is quite simply more important than ever to stick with a consistent, predictable, repeatable process that can adapt to the ever-changing market.

Any questions or comments?  We’re here to listen.  You can contact me at adil.mohammed@assante.com or 905.335.1950.