Tag Archives: Inflation

Retail Investor Inflation Strategy

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Inflation refers to an aggregate increase in prices, commonly measured by the Consumer Price Index (CPI).

The federal government has pumped trillions of dollars into the economy through deficit spending and stimulus measures since the COVID-19 pandemic began. Meanwhile, the central bank of the United States, the Federal Reserve, has dropped interest rates to near zero and has committed to keeping them there through 2023.

The Federal Reserve’s mandates are to manage the money supply and set the federal funds interest rate in an attempt to keep inflation within a reasonable limit. This reasonable level of inflation is maintained because it encourages people to spend now, thereby promoting economic growth, rather than saving, as a dollar today is worth more than the same dollar tomorrow on average.

A constant level of inflation helps maintain price stability and is thought to maximize employment and economic well-being. Investors expect returns greater than this “reasonable,” average level of inflation, and workers expect wage increases to keep pace with the increasing cost of living.

The Consumer Price Index tracks prices for a broad range of products such as gasoline, healthcare, and groceries. The CPI rose 6.2% in October from the same month in 2020, the biggest spike since December 1990, according to the Labor Department.

High and variable inflation is considered bad for both investors and the wider U.S. economy because it can eat away at the value of financial assets denominated in the inflated currency, such as cash and bonds, particularly longer term bonds with more interest rate risk.

The prospect of variable or high inflation introduces uncertainty to both the economy and the stock market, which doesn’t really benefit anyone. This uncertainty or variable inflation distorts asset pricing and wages at different times. Prices also tend to rise faster and earlier than wages, potentially contributing to economic contraction and possible recession.

“Cash is not a safe investment, is not a safe place because it will be taxed by inflation.” Ray Dalio, Bridgewater Associates

In an inflationary environment, “cash is trash” since inflation operates like a tax which causes saved dollars lose value over time. High inflation rates decrease the purchasing power of money and it discourages people from holding cash assets and saving. “Cash is not a safe investment, is not a safe place because it will be taxed by inflation,” Bridgewater Associates’ Ray Dalio, the founder of the world’s biggest hedge fund said on CNBC Squawk Box.

Here are several suggestions for investors to consider to counter the risk and derisive impact of inflation on assets and the economy.

  • Consider buying equity stocks like bank stocks or consumer goods companies that will benefit from higher inflation or higher interest rates. Banking, consumer staples, energy, utility, and healthcare equities are likely to perform well. Banks would come out ahead if the Federal Reserve eventually raises interest rates to combat inflation, and banks’ spreads between loans and deposits widen. Also, look for companies that benefit from rising labor costs and be very attentive to how much you pay for (e.g., the intrinsic value) of risk assets.
  • Consider buying TIPS, or Treasury inflation-protected securities, which are a useful way to protect your investment in government bonds. These U.S. government bonds are indexed to inflation, so if inflation moves up, the effective interest rate paid on TIPS will too. TIPS bonds pay interest every six months, and they’re issued in maturities of 5, 10 and 30 years. Because they’re backed by the U.S. federal government, they’re considered among the safest investments in the world.
  • Avoid fixed income assets such as corporate and government non-TIP bonds. If rates rise sharply, their principal value will take a major hit. If rates climb, then certificates of deposit, fixed annuities, bonds, and bond funds purchased today will look less attractive in the future. Similarly, buying a lifetime income annuity is less enticing in an inflationary environment. The monthly check you get for the rest of your life will lose value more quickly with high inflation.
  • Keep the right sort of debt. Don’t pay off that home mortgage or real estate investment mortgages early, you’re better off paying it off over time with watered-down dollars. Homeowners carrying fixed mortgages with low interest rates are in a great position. It’s highly recommended to refinance your mortgage to lock in low rates. If inflation takes off, homes prices are likely to climb and your fixed monthly payment may appear like a real bargain in a few years.
  • Consider commodities or gold. Investing in oil, natural gas, wheat and corn can be good hedges against inflation. Gold has traditionally been a safe-haven asset for investors when inflation revs up or interest rates are very low. Gold tends to fare well when real interest rates – that is, the reported rate of interest minus the inflation rate – go into negative territory. Investors often view gold as a store of value during tough economic times.
  • Make essential purchases and charitable giving. If consumers expect to spend money on home goods, renovations, car repairs, or other products and services, they might be better off doing so now, before prices climb even higher.
  • Expect rising health costs. Health costs have risen faster than inflation for years. The pandemic, which is driving some health professionals out of the field, could accelerate that trend.

Keep in mind that inflation is always happening within the economy, but hopefully at a relatively low and steady rate, and kept under control by the Federal Reserve. Investors with a long time horizon, a high tolerance for risk, and a high allocation to stocks shouldn’t be worried about short-term inflation fears.

However, it’s perfectly suitable and even desirable for retirees, risk-averse investors, and those with a short time horizon to have some allocation to inflation-protected assets like TIPS, REITs and bank stocks.

Rising inflation is a big concern for investors, but it remains to be seen whether current high levels of inflation will persist or end up being due to “transitory” factors. Investors will likely come out ahead using assets like equity stocks, REITs, short-term nominal bonds, and TIPS to hedge against inflation.

References:

  1. https://www.barrons.com/articles/protect-finances-from-inflation-51637782342
  2. https://www.optimizedportfolio.com/inflation/
  3. https://www.bankrate.com/investing/inflation-hedges-to-protect-against-rising-prices/

Best Business to Own When Inflation Spikes

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Invest in asset-light businesses with pricing power.

In a letter to Berkshire Hathaway shareholders, the best type of business to own when inflation spikes, according to Berkshire Hathaway Chairman and CEO Warren Buffett, have two characteristics that make a business well adapted to an inflationary environment:

  1. An ability to increase prices easily, and
  2. An ability to take on more business without having to spend too much in order to do it.

In other words, aim to invest in asset-light businesses with pricing power.

Buffett also stated that the best business to own is one that doesn’t require continuous reinvestment of capital because it becomes more and more expensive as the value of a dollar drops.

“The best businesses during inflation are the businesses that you buy once and then you don’t have to keep making capital investments subsequently,” Buffett said, adding that “any business with heavy capital investment tends to be a poor business to be in inflation and often it’s a poor business to be in generally.”

Businesses like utilities or railroads “keep eating up more and more money” and aren’t as profitable, he explained. He prefers to own companies that people have a connection to. That is why “a brand is a wonderful thing to own during inflation,” Buffett said. Owning part of “a wonderful business,” as Buffett said in 2009, is useful because no matter what happens with the value of the dollar, the business’ product will still be in demand.

Buffett also said that it’s particularly handy to own real estate during times of inflation because the purchase is a “one-time outlay” for the investor, and has the added benefit of being able to be resold.

Inflation quietly eats away at earnings and purchasing power.

When the economy exhibits strong economic growth, there is a higher demand for goods and services, which in effect increases prices of those goods and services; that’s attributed to inflation. Essentially, the rate of inflation increases when demand in the economy is higher than supply, causing an overall price rise.

Inflation also impacts money sitting in the bank. While you may be receiving interest on savings from a money market account, the growth of inflation can outpace that of the savings rate offered by the bank. Keeping all your savings in cash is warranting your liquid assets a definite loss to inflation.

Effectively, your money does not grow at a higher rate, but loses purchasing power over time compared to if it was properly invested in equity assets.

Inflation

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of [all] their citizens.” John Maynard Keynes

Inflation is tracked using the Consumer Price Index, known as the (CPI). This index, reported by the U.S. Bureau of Labor Statistics each month, measures the average change over time of prices consumers pay for goods and services.

The immediate effects of inflation are the changes in the behavior of consumption habits. In the long-term, inflation erodes the purchasing power of your income and accumulated wealth.

“Inflation reduces the ‘power’ of each dollar you have,” says Rob Isbitts, co-founder of The Hedged Investor in Weston, Florida. “A dollar is a dollar, but what it buys can be less in the future than it is today.”

Purchasing power risk – also known as inflation risk – is when the real interest rate, which accounts for adjusted inflation, shows the gain or loss in purchasing power.

“Inflation reduces the ‘power’ of each dollar you have,” says Rob Isbitts, co-founder of The Hedged Investor in Weston, Florida. “A dollar is a dollar, but what it buys can be less in the future than it is today.”

Assets That Protect Against Inflation

Inflation can pose a threat to investments since prices that increase over time can decrease the value of your savings.

And, financial experts agree that there is no way to fully protect your investments against inflation. Nonetheless, there are ways to help protect against this risk. These experts say having a substantial allocation to stocks is important for growth potential while offsetting against inflation risk.

In the long term, the stock market is expected to outperform the inflation rate. Stocks are commonly thought of as an inflation protection asset since, over time, stock performance will outpace inflation. These assets are seen as a hedge against inflation:

  • TIPS, or Treasury Inflation-Protected Securities, which are bonds backed by the full faith of the U.S. government and protect against rising prices, make a very safe asset
  • REITs, or real estate investment trusts, are an organic hedge against inflation. When prices increase, real estate values increase as well. This asset is highly correlated with inflation, which means REIT returns are higher when inflation increases.
  • Gold is an asset that might provide protection against inflation and a good safeguard of inflation over the long run,

Inflation can significantly weaken your purchasing power and the performance of your investments and thus impact their value. That’s why acting to suppress the dangers of inflation is important to preserve the value of your cash flow and wealth in the long run.

References:

  1. https://finance.yahoo.com/news/warren-buffett-says-best-type-195900081.html
  2. https://money.usnews.com/investing/investing-101/articles/how-inflation-and-deflation-impact-your-investments
  3. https://www.cnbc.com/2021/08/19/warren-buffett-inflation-best-businesses.html

Global Inflation Worries

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“Inflation will be higher and more persistent than people expect.” Mohamed El-Erian, Allianz & Gramercy Advisor

Higher and more persistent inflation may now be an unavoidable economic fact of life for Americans, and it’s starting to make a lot of economists, investors and public leaders worry. They, specifically economists, collectively believe inflation is primed for rapid growth domestically as trillions in federal stimulus spending is layered on top of the Federal Reserve’s loose monetary policy.

This level of unadulterated fiscal spending could mean that investors will have to get used to inflation, higher interest rates, more market volatility and lowered returns on invested capital.

In conjunction to domestic and global inflation concerns, there exist two significant global economic worries for individuals and investors:

  • Global supply chain constraints which are significant and will get worst whether it is disrupted supply chains or labor worries, and
  • Global tightening of monetary conditions and less liquidity.

But, major shocks to the economy tend to be caused by either a major policy mistake or market accidents. Yet, we’re unlikely to witness double digit inflation in the United States.

The Federal Reserve and the Biden Administration contend that the elevated inflation readings will prove transitory. The Fed and Administration view that the current inflation stems chiefly from temporary factors such as supply bottlenecks and a spike in post-pandemic consumer demand.

The August inflation report showed that prices increased by 5.4% year over year in July. Wages increased, too—but not by enough to offset inflation.

And, Americans know inflation when they see it: retail shops and restaurants are raising their prices on consumers, and prices of used cars and trucks were 32% higher in August than they were a year earlier, and workers are discovering bargaining power over wages for certain positions for the first time in years, according to Barron’s. “Inflationary pressures are likely to rise because everyone is spending—including the government—and it becomes a self-sustaining cycle,“ says Karen Karniol-Tambour, co-chief investment officer for sustainability at Bridgewater Associates.

“When you live in a world of abundant liquidity, investors tend to take on too much risk.” Mohamed El-Erian

Congress has assigned a dual mandate for the Federal Reserve: Foster maximum employment and maintain price stability. The FOMC has interpreted maintaining price stability as keeping inflation growing at about 2% a year over the long-term.

Over the past two decades, the Federal Reserve has been unable live up to its two percent inflation mandate. Using the Fed’s preferred gauge of inflation, core Personal Consumption Expenditures (PCE), which tracks price changes over time without volatile energy and food costs, inflation has remained stubbornly below the Fed’s 2% annual target since the 2007 – 09 Great Recession, except for a brief stretch in early 2012 and much of 2018.

Going from a disinflationary world to an inflationary world

Evidence that some of the issues that might spur inflation could abate ahead, particularly some of the supply chain issues. Additionally, unit labor costs remain low, meaning that companies still aren’t spending substantially more for productivity, which also could tamp down inflation.

Federal Reserve Chair Jerome Powell has been resolute in his commitment to seeing the whites of inflation’s eyes before raising rates or paring back quantitative easing. But some market observers believe the Fed is being too lax.

“Financial conditions should remain quite accommodative for a while and in our view risks an overshoot,” said Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income.

The drivers of global inflation are many and complex. They include global economic and policy forces as well as domestic. Yet, it’s important to keep in mind that the rise in inflation isn’t necessarily life altering. Although, policy makers can’t hold on to the “mystical attraction of transitory inflation” when the facts on the grow indicate the contrary, according to Mohamed El-Erian. Given the extraordinary level of fiscal and monetary economic stimulus, inflation may be less transitory than previously thought.

References:

  1. https://www.forbes.com/advisor/investing/inflation-worries/
  2. https://www.cnbc.com/video/2021/10/25/mohamed-el-erian-were-not-anywhere-near-risk-of-hyperinflation.html
  3. https://www.pimco.com/en-us/insights/viewpoints/want-to-mitigate-inflation-take-a-portfolio-approach
  4. https://www.barrons.com/articles/government-economy-stock-market-51633705211

Loss of Purchasing Power: Is $1 million enough for retirement?

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“One million dollars doesn’t buy as many Cadillac Escalades as it used to.”

Today, $1 million no longer buys as many McDonald’s Big Mac sandwiches or Rolex Submariner watches or Ford F150 trucks as it once did thirty years ago.  There’s a good reason for that called ‘loss of purchasing power’ which is a byproduct of inflation. That’s because $1 million of purchasing power in 1970 was the equivalent of nearly seven million dollars today, according to Motley Fool. And as recently as 1990, a million dollars has lost half its buying power since then, meaning you’d need two million today to have the same buying power as you did in 1990.

As a result of normal inflation and loss of purchasing power, $1 million retirement nest egg today definitely will not offer you as comfortable a retirement lifestyle as it did a few years ago or a few decades ago.

Retirement is not an age, but a number

Financial preparedness is more important than reaching a certain retirement age. And, to answer the question of whether $1 million or any amount of money is enough for retirement, the answer depends on what you want your retirement to look like.

It’s important to ensure you have enough savings and income to sustain your spending and lifestyle in retirement. If you don’t have enough money set aside to pay for your retirement, then you may have to delay retiring. And no matter where you are on your retirement journey, you can make your financial number. No matter how little you have or how much time you have left until you want to retire, you can always improve your financial situation. Getting started and creating a retirement plan can carry you a long way.

A 2018 Northwestern Mutual study found that one in three Americans has less than $5,000 saved up for retirement, and 21% of Americans have no retirement savings at all. Overall, Americans are feeling underprepared and less confident regarding the financial realities of retirement, according to the data.

Despite these findings regarding the woeful retirement savings rate by Americans, it’s still not too late to enjoy the kind of life you’ve worked so hard for… and the retirement you deserve.

One of the most important goals for Ameriocans facing retirement is knowing that they can sustain their desired level of spending and lifestyle throughout their lives, with a sense of financial peace of mind and without the fear of running out of money.  For our purposes, financial peace of mind is the knowledge that, no matter your level of savings or degree of market volatility, you are confident that you are unlikely to run out of money during retirement to support your level of spending and  lifestyle.

Taking the financial road less traveled

Conventional wisdom recommend that older Americans should reduce their stock allocation in retirement and move into more safe investments such as bonds and cash.  Although this may seem the less risky road to take in your retirement years, a few experts do not agree.  If you expect to maintain your purchasing power into future, you must stay invested in stocks.

“The idea that a 60-year-old retiree should be investing primarily in conservative investments is an antiquated way of approaching personal finance”, says Jake Loescher, financial advisor, at Savant Capital Management in a 2017 U.S. News article. “Historically, the rule of thumb stated that an individual should take the number 100, subtract their age, which will define the amount of stocks someone should have in their portfolio. For a 60-year-old, this obviously would mean 40 percent stocks is an appropriate amount of risk.”

“A better approach would be to perform a risk assessment and consider first how much risk an individual needs to take based on their personal circumstances,” Loescher says.

According to the article, there are five circumstances when retirees should eskew conventionl wisdom:

  1. The likelihood you’ll live into your 90s or beyond. Since life expectancy is much longer these days and in today’s low-interest environment, you face an increase risk of your nest egg not keeping up with inflation over the long haul.
  2. If you don’t have enough cash for retirement. If you didn’t accumulate enough retirement assets to sustain an expected lifestyle, it becomes essential to decide how much capital in a retirement portfolio you’re willing to risk for the potential upside appreciation.
  3. When interest rates are low. Low interest rates makes the capital risk seem greater than the value bonds might provide due to a loss of purchasing power.  Taking a total-return approach, using low volatility, dividend-paying stocks to replace part of our typical bond component seems the best approach.
  4. If you have estate planning needs. If you don’t depend totally on your investments for income, then your money may be providing a bequest for charity or an inheritance for children.
  5. For historical purposes. The stock market has outperformed all other asset classes over the last century.

In retrospect, retirees will need to allocate a certain portion of their assets to higher-return equity investments to achieve long-term retirement objectives – be it longevity of assets, a desired level of sustainable income, the ability to leave a legacy, etc.

Essentially, the stock market has outperformed all other asset classes over the last century. And studies continue to show that unless you are within three years of retirement, the average variability of stocks relative to their returns is superior to that of Treasurys, municipal and corporate bonds.  Thus, the right course of action is for older Americans to stay invested in the stock market past age 60 which will provide you at least 20 years, on average, to ride out the long-term volatility inherent in equities.

References:

  1. https://www.fool.com/ext-content/is-1-million-enough-for-retirement/
  2. https://www.pimco.com/en-us/insights/investment-strategies/featured-solutions/worried-about-retirement-pimcos-plan-to-help-retirement-savings-last-a-lifetime
  3. https://money.usnews.com/investing/articles/2017-07-24/5-reasons-to-stay-in-the-stock-market-in-your-60s
  4. https://www.pimco.com/en-us/insights/investment-strategies/featured-solutions/income-to-outcome-pimcos-retirement-framework
  5. https://money.usnews.com/money/blogs/on-retirement/2011/03/22/why-retirement-is-not-an-age

Buffett on Inflation

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“Inflation often feels like an abstract concept, but it hits everyday people the hardest.” Warren Buffett

Inflation is when the dollars in your wallet lose their purchasing power — either because the money supply has dramatically increased or because prices have surged, according to Bankrate.com.

Effectively, inflation occurs when the cost of goods and services in the economy goes up over a sustained period of time. Yet, inflation doesn’t happen overnight, and it also doesn’t happen when the cost of one particular good or service goes up.

From an economics perspective, inflation refers to price increases to the broader economy. And, price increases aren’t always synonymous with inflation — and some economic experts say a little bit of inflation is actually good for the economy. That’s for two main reasons: One, it prevents a deflationary trap, which experts say can be even worse than deflation because money loses value. Another reason is because households make better financial decisions when they expect stable and low prices.

“We may see prices rise on certain things like gas or milk, but it’s not necessarily inflation unless you see prices rising sort of across the board, across many different products and services,” says Jordan van Rijn, senior economist at the Credit Union National Association (CUNA).

The Berkshire CEO described high inflation as a “tax on capital” that discourages corporate investment. The “hurdle rate,” or the return on equity needed to generate a real return for investors, climbs when prices rise, Buffett said. “The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil,” Buffett added.

Buffett pointed out inflation can hurt more than income taxes, as it’s able to turn a positive return on investment into a negative one. If prices have climbed enough, people who make a nominal return on their investment may be left with less purchasing power than before they invested.

Inflation Causes

Given the federal government’s unprecedented loose monetary policy, fiscal spending spree and money-printing splurge over the last year, many economists have warned that such fiscal irresponsibility could result in a destructive wave of inflation.

‘I worry about inflation. I do not believe inflation is going to be transitory.’ Larry Fink, chairman and CEO, BlackRock Inc.

Defenders of federal government pandemic monetary and fiscal interventions have insisted that any resulting price inflation is just transitory. But recent data is showing that price inflation is hitting new highs and many economists believe that inflation is deep rooted and non-transitory.

However, the June’s Consumer Price Index (CPI) shows prices once again sharply on the rise. From June 2020 to June 2021, the data show that consumer prices rose a staggering 5.4 percent. Larry Fink, Chairman and CEO of BlackRock Inc., isn’t convinced by the Federal Reserve’s arguments that U.S. inflation pressures will fade away once supply bottlenecks and other temporary factors resulting from the COVID-19 pandemic fade away.

Economists lump inflation causes into two categories: demand-pull and cost-push inflation.

Cost-push occurs when prices increase because production is more expensive; that can include rises in labor costs (wages) or material prices. Firms pass along those higher costs in the form of higher prices, which then cycles back into the cost of living.

On the flip side, demand-pull inflation generates price increases when consumers have resilient interest for a service or a good.

While price inflation has many causes, much of the current inflation can be traced back to the policy of the Federal Reserve. The Fed essentially created trillions of new dollars to pump into the economy in the name of “pandemic stimulus.”

“The quantity of money has increased more than 32.9% since January 2020,” Federal Economic and Education (FEE) economist Peter Jacobsen explained in May. “That means nearly one-quarter of the money in circulation has been created since then. If more dollars chase the exact same goods, prices will rise.” 

“We are seeing very substantial inflation,” Warren Buffet said at a recent shareholder meeting. “It’s very interesting. We are raising prices. People are raising prices to us and it’s being accepted.”

The typical person’s standard of living declines as a result of price inflation, because what really matters is not what number appears on your paycheck but the purchasing power of your paycheck. Working-class Americans suffer tremendously when their energy bill increases by nearly 25 percent in just one year, for example.

It is not a secret that stocks, like bonds, do poorly in an inflationary environment, according to Warren Buffett.

“There is no mystery at all about the problems of bondholders of in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner” Buffet states. “You hardly need a Ph.D. in economics to figure that one out.”

Regarding stocks, the conventional wisdom believes “…that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms; let the politicians print money as they might.”

The main reason it, stocks as a hedge against inflation, do not turn out the way conventional wisdom believed, according to Buffett, is that “stocks, in economic substance, are really very similar to bonds”.

References:

  1. https://www.bankrate.com/banking/federal-reserve/what-is-inflation/
  2. https://fee.org/articles/inflation-just-hit-a-13-year-high-here-s-why-you-should-care/
  3. https://markets.businessinsider.com/news/stocks/warren-buffett-berkshire-hathaway-warned-inflation-prices-tapeworm-investors-businesses-2021-5
  4. https://www.cnbc.com/2018/02/12/warren-buffett-explains-how-to-invest-in-stocks-when-inflation-rises.html
  5. https://fee.org/articles/the-costs-are-just-up-up-up-warren-buffett-issues-grave-warning-about-inflation/
  6. https://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/
  7. http://csinvesting.org/wp-content/uploads/2017/04/Inflation-Swindles-the-Equity-Investor.pdf

What the Inflation of the 1970s can Teach Us Today

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A Wall Street Journal survey finds that “strong economic rebound and lingering pandemic disruptions fuel inflation forecasts above 2% through 2023”.

The U.S. inflation rate reached a 13-year high recently, triggering a debate about whether the country is entering an inflationary period similar to the 1970s, according to WSJ. Americans should brace themselves for several years of higher inflation than they’ve seen in decades, according to economists who expect the robust post-pandemic economic recovery to fuel brisk price increases for a while.

Economists surveyed this month by The Wall Street Journal raised their forecasts of how high inflation would go and for how long, compared with their previous expectations in April.

On average, the WSJ survey respondents expect a widely followed measure of inflation, which excludes volatile food and energy components, to be up 3.2% in the fourth quarter of 2021 from a year before. They forecast the annual rise to recede to slightly less than 2.3% a year in 2022 and 2023.

That would mean an average annual increase of 2.58% from 2021 through 2023, putting inflation at levels last seen in 1993.

References:

  1. https://www.wsj.com/articles/higher-inflation-is-here-to-stay-for-years-economists-forecast-11626008400

Inflationary Pressures are a Real and Present Concern

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“Inflation jumped 5 percent in the past year, the fastest pace in 13 years.”

Inflation in the US has jumped to the highest rate since 2008.  For the past decade, inflation has averaged under 2 percent a year. But suddenly, inflation is rising much faster than anticipated and planned by the Federal Reserve. For instance, inflation rose 5 percent between May 2020 and May 2021, the Labor Department reported.

Inflation results when demand exceeds supply in an economy. When the economy grows faster than its ability to provide goods and services demanded by consumers, prices rise. When the economy grows more slowly than its potential growth rate, prices tend to fall. Factors that affect an economy’s growth rate include the supply of labor and the productivity of those workers.

Inflation is imply defined as the price of a good or service increasing over time. Conversely, you can also define inflation by looking at the value of the dollars purchasing those goods and services. Said another way, while you might agreed that the price of good and services have increased, you can also state the dollars you spend now purchase less quantity of goods and services … and by extension, the dollars themselves are clearly worth less.

Money supply and budget deficits

We’ve learned that inflation is, “always and everywhere a monetary phenomenon,” according to economist Milton Friedman. Money supply growth is a requirement, but in and of itself, it’s not enough to cause inflation. The money needs to find its way into the economy and turnover rapidly to generate inflation. (This is referred to as the velocity of money or ratio of M2 money supply to gross domestic product, or GDP.) In recent years, the velocity of money has fallen sharply.

Rising budget deficits are not necessarily linked to inflation, either, but can contribute to an overheating economy. It all depends on whether it stimulates demand to exceed supply. From a long-term perspective, there has been little correlation in recent years between the level of debt in the economy and inflation.

The causes of present inflation and the primary explanations are:

  • Pent-up demand following the COVID-19 shutdown.
  • Base effects (essentially older low values rolling off).
  • A massive increase in the supply of dollars.

Rising Prices 

“Inflation is taxation without legislation.” – Milton Friedman.

With commodity prices soaring, money supply growth exploding, and government spending surging, there is a palpable fear of a return to 1970s-style inflation. I get it. I remember those times.

Core inflation, which strips out volatile items such as food and energy, leaped to the highest level since 1992. It rose 3.8% year-on-year, up from 3% in April.
Other official data showed that the number of initial claims for jobless benefits fell to its lowest since mid-March 2020, when the first wave of Covid-19 hit.

The cost of used cars and trucks climbed 7.3% in May from April, accounting for a third of the increase in inflation. Prices were 29.7% higher than a year earlier. They have risen in recent months because of a global semiconductor shortage that has held back car production, pushing people to enter the market for second-hand vehicles instead.

Energy prices rose, by 28.5% year-on-year, including a 56% jump in gasoline prices compared with May 2020, when demand slumped due to the pandemic. And, gasoline prices are destined to go higher with the cancelation of the cross-border permit for the Keystone XL pipeline and suspension of the program for oil and gas leasing on federal lands and waters.

The cost of flights, household furnishings, new cars, rental cars and clothing rose during May.


 

What should investors do?

In response to inflation, investors should:

  • Must become awareness of inflation. Inflation is likely to increase throughout the year (and perhaps further), and bonds are likely to at least be less of a stalwart than they have over the past 40 years. It is important to realize that is possible and you should all be prepared for lower near-term performance in fixed income markets.
  • Diversification is key. Equities, for example, have historically been a reasonable asset during certain inflationary periods as companies can often pass through increased costs.
  • Explore other forms of inflation protection, as well as a broader diversification of fixed income instruments.

Inflation is clearly present for U.S. consumers in the grocery stores, at gas stations and in vehicle sales. Fears over rising prices has investors fearing that pent-up demand and supply chain bottlenecks would create inflationary pressures, and force the Federal Reserve to “tamper” their monetary stimulus program and dampen demand by increasing interest rates.

References:

  1. https://www.bls.gov/news.release/cpi.nr0.htm
  2. https://blog.massmutual.com/post/markets-inflation-vanderburg
  3. https://www.schwab.com/resource-center/insights/content/is-1970s-style-inflation-coming-back
  4. https://www.schwab.com/resource-center/insights/content/schwab-market-update
  5. https://www.theguardian.com/business/2021/jun/10/us-inflation-highest-rate-stocks-consumer-price-index

Stimulus, Inflation, Unsustainable Debt and America | Fidelity Investments and Peterson Foundation

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“America has been on an unsustainable fiscal path for many years, since long before this pandemic.” The Peter G. Peterson Foundation

  • The new $1.9 trillion stimulus spending package, on top of trillions already spent to revive the economy, is driving the national debt to unprecedented levels.
  • History shows that high government debt often leads to inflation, and an uptick in inflation is expected this year as the economy recovers.

The $1.9 trillion federal stimulus package will help many families, businesses, and state and local governments hard hit by the pandemic. But it is also fueling concerns about the ballooning federal debt, inflation, and how investors can protect themselves.

The Congressional Budget Office projected that the federal budget deficit will rise during the second half of the decade and climb steadily over the following 20 years.  By 2051, the federal debt is expected to double as a share of the economy.

The projections by the nonpartisan office forecast a more challenging long-term outlook, as interest costs on the national debt rise and federal spending on health programs swells along with an aging population.  “A growing debt burden could increase the risk of a fiscal crisis and higher inflation as well as undermine confidence in the U.S. dollar, making it more costly to finance public and private activity in international markets,” the CBO report said.

Our federal fiscal budget has structural problems, driven by well-known and predictable factors that include an aging population, rising healthcare costs and compounding interest—along with insufficient revenues to meet our commitments, according to The Peter G. Peterson Foundation.

Over the last 20 years, the federal government’s debt has grown faster than at any time since the end of World War II, running well ahead of economic growth. In addition to COVID-related spending, rising federal debt has been driven by longer-term trends including increasing Social Security and Medicare spending for an aging population. Today, according to the Congressional Budget Office, the federal debt is $22.5 trillion, more than 100% of gross domestic product (GDP).

Why debt matters

New Fidelity research suggests that higher debt can slow economic growth, and ultimately lead to higher inflation and more volatile financial markets. Warns Dirk Hofschire, senior vice president of asset allocation research at Fidelity Investments: “Debt in the world’s largest economies is fast becoming the most substantial risk in investing today.”

In the short term, Fidelity’s director of global macro Jurrien Timmer says a market consensus has emerged that inflation will rise in the second half of 2021: “An inflationary boom could result from the combination of COVID infections falling, vaccinations rising, ongoing massive fiscal stimulus, pent-up consumer demand, and low interest rates.”

FEDERAL DEBT IS ON AN UNSUSTAINABLE PATH

Longer term, Hofschire says, “The rise in debt is unsustainable. Historically, no country has perpetually increased its debt/GDP ratio. The highest levels of debt all topped out around 250% of GDP. Since 1900, 18 countries have hit a debt/GDP level of 100%, generally due to the need to pay for fighting world wars or extreme economic downturns such as the Great Depression. After hitting the 100% threshold, 10 countries reduced their debt, 7 increased it, and one kept its level of debt roughly the same.”

Only time will tell which way the US goes and when. But Hofschire thinks “government policies are likely to drift toward more inflationary options.” Among them:

  • Federal spending aimed at lower- and middle-income consumers
  • Increased public works spending not offset by higher taxes
  • Protectionist measures with a “made in America” rationale
  • Infrastructure upgrades targeting sectors such as renewable energy, 5G telecom, and health care
  • Higher inflation targeting by the Federal Reserve
  • Mandatory pay increases for workers benefiting from government assistance

In the longer term, if further free-spending fiscal policies are adopted while interest rates stay low and credit remains abundant, the likelihood of inflation could increase. But history suggests the magnitude and timing is uncertain. Many predicted an inflation surge the last time the federal government embarked on major fiscal and monetary stimulus after the global financial crisis, but inflation mostly failed to appear.

THE GROWING DEBT IS CAUSED BY A STRUCTURAL MISMATCH BETWEEN SPENDING AND REVENUES according to The Peterson Foundation

Why the national debt matters, according the The Peter G. Peterson Foundation:

  • High and rising federal debt matters because it reduces the county’s flexibility to plan for and respond to urgent crises.
  • Debt matters because growing interest costs make it harder to invest in our future — to build and sustain infrastructure, enhance education and support an economy that creates job growth and rising wages.
  • Debt matters because it threatens the safety net — critical programs like Social Security, Medicaid, Medicare, SNAP and Unemployment Compensation are essential lifelines for the most vulnerable populations.
  • Debt matters because America faces emerging and ongoing challenges that will require fiscal resources to keep the country safe, secure and strong — challenges like socioeconomic injustice, climate change, affordable health care, wealth and income inequality, international conflicts and an increasingly complex and competitive global economy.
  • Debt matters because the nation should care about its children and grandchildren. Borrowing more and more today reduces the opportunities and prosperity of the next generation.

The U.S. faces a range of complex, unprecedented health, economic and societal challenges, set against the backdrop of a poor fiscal outlook that was irresponsible and unsustainable before the crisis.

Building a brighter future for the next generation must become an essential priority for America, and the high cost of this health and economic crisis only makes that challenge more urgent. Once America has emerged from the pandemic, it will be more important than ever for its elected leaders to address the unsustainable fiscal outlook and manage the burgeoning national debt, to ensure that America is more prepared, better positioned for growth, and able to meet its moral obligation to future generations.

References:

  1. https://www.cbo.gov/publication/57038
  2. https://www.fidelity.com/learning-center/personal-finance/government-spending-2021?ccsource=email_weekly
  3. https://www.pgpf.org/what-does-the-national-debt-mean-for-americas-future

* The Peter G. Peterson Foundation is a non-profit, non-partisan organization that is dedicated to increasing public awareness of the nature and urgency of key fiscal challenges threatening America’s future, and to accelerating action on them. To address these challenges successfully, we work to bring Americans together to find and implement sensible, long-term solutions that transcend age, party lines and ideological divides in order to achieve real results.

Looming Threat of Inflation

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“Inflation destroys savings, impedes planning, and discourages investment. That means less productivity and a lower standard of living.” Kevin Brady

Brian Wesbury, Chief Economist at First Trust Advisors, is concerned about inflation increasing faster than the Federal Reserve anticipates. Wesbury said that he is focused on the rapid increase in the M2 measure of the money supply. This measure has soared since COVID-19 hit the US, up about 25% from a year ago, the fastest growth on record.

From his viewpoint, the rapid increase in M2 is the key difference between the current situation and the situation in the aftermath of the Financial Crisis of 2008-09. During that first round of Quantitative Easing and big spending bills (like TARP), the M2 measure remained subdued because the Fed kept banks from lending, in part by raising capital standards. As a result, inflation remained subdued as well.

The late great economist Milton Friedman stress that policy makers watch M2: Nominal economic growth and inflation will tend to track M2 broadly over time, adjusted for any fluctuations in the velocity of money, the speed with which money circulates through the economy.

The US economy is healing faster than expected, while the US Congress and President Biden are intent on pouring at least one more massive government spending stimulus into the system, according to Wesbury. They are doing this even though the pandemic is waning, and a double-dip recession seems highly unlikely.

The big risk for the next couple of years is an upward surge in inflation that’s larger than anything we’ve experienced in the past couple of decades.

“I think the inflation prospects for the U.S. over the next five or six, seven years, are quite serious. You cannot have a bumper crop in apples without the value or the price of each apple falling. The Fed has had the largest increase in the monetary base in the history of the U.S., from colonial times to the present, times ten.” Arthur Laffer, an Economist known for his tax revenue theory called the Laffer Curve

He still project 2.5% CPI inflation for 2021, as the government’s measure of housing rents holds the top-line inflation number down. But commodity prices are likely to continue rising and overall inflation will as well in in 2022 and beyond. There is an old saying: When the Fed is not worried about inflation, Wesbury states, “the market should be worried.”

References:

  1.  https://www.ftportfolios.com/Commentary/EconomicResearch/2021/3/1/powell-disses-uncle-milty

Rising Bond Yield Leads to Market Sell-off | CNBC

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The culprit behind the recent stock market sell-off was the rapid rise in 10-Year U.S. Treasury bond yields. The 10-year Treasury yield remained above 1.4%, after surging to 1.6% in the previous day session to its highest level since February 2021 and more than 0.5% higher since the end of January, according to CNBC.

The spike in the 10-year yield , which is used as a benchmark for mortgage rates and auto loans, is reacting to positive economics as vaccines are rolled out and GDP forecasts improve, which should benefit corporate profits. But the move could also signal faster-than-expected inflation ahead. The sheer pace of the rise has also had the effect of dampening investors’ appetite for richly valued areas of the market like technology and other growth stocks. Higher rates reduce the value of future cash flows so they can have the effect of compressing equity valuations.

All three stock benchmarks — Dow Jones Industrial Average , Nasdaq and S&P500 — were tracking for weekly losses ahead of the final trading day of February. The Nasdaq was down nearly 7% from its February 12, 2021, record closing high. The Dow and S&P 500 both remain solidly in the green for the month. However, the S&P 500 was off almost 2.7% from its last record closing high, also on February 12, 2021, and the Dow had its worst day in nearly a month on Thursday.

Additionally, inflation concerns are being stoked on the thought that the $1.9 trillion COVID-19 stimulus bill — which passed the House of Representatives — on top of accelerating growth could overheat the economy.

Economists and investment managers say the bond market is reacting to positive economics as vaccines are rolled out and GDP forecasts improve, which should benefit corporate profits. But the move could also signal faster-than-expected inflation ahead.

References:

  1. https://www.cnbc.com/2021/02/26/5-things-to-know-before-the-stock-market-opens-feb-26-2021.html