What to Know About Inflation
- Inflation is a normal market behavior and is in fact a sign of economic recovery
- Current inflation rates are going to appear high in part because of the economic downturn due to COVID-19
- Inflation is worth monitoring, but we believe that fears of rampant long-term inflation are largely unfounded
- Real assets can serve as an important hedge against inflation
It seems that you can hardly scan the headlines without seeing talk of inflation recently. How high is it? How much higher could it go? Should we be worried? And this is certainly understandable. Inflation is a significant indicator of how the economy is performing and predicting what the economy may do in the future has not been a straightforward exercise over the past year. Inflation, however, like many aspects of finance, including risk, is not a simple binary of good or bad. Inflation is, in fact, likely a good sign at a moment when the economy is in the midst of a recovery, signaling growth. At other times, inflation has been a problem because it ran unchecked or out of sync with the overall pace of the economy. Whether inflation is a positive or negative signal for the economy depends on this context.
With that said, inflation is an important data point and, while we do not expect inflation to be a significant long-term problem at present, there are factors we continue to watch for as we move forward in the broad economic recovery.
What’s Really Happening with Inflation
We are currently seeing an increase in inflation, that much is not under debate. This is an expected consequence of the continued reopening of the economy and the resulting economic recovery. Thanks to a combination of pent-up demand after the past year and decreased supply to meet that demand, we expect inflation to spike in the next few months as spending increases and prices increase versus last year. The core Consumer Price Index (CPI) ended May up 3.8%, compared to 1.2% in May of 2020. Prior to the start of the pandemic, inflation had been hovering around 2% for the better part of two years.
12-month Percentage Change, Consumer Price Index, All Items Excluding Food and Energy
While the CPI is frequently referenced as a measure of inflation, it is also not the only data point available, and is not the one most often looked at by the Fed when determining whether inflation has reached a point where adjustments must be made on their part. The Personal Consumption Expenditures price index (PCE) is what the Fed watches most closely, and it has in some measures been rising more slowly than the CPI. As of the most recent data release at the end of April, the total PCE stood at 3.6% while the equivalent CPI was at 4.2%. This may explain some of the gaps between popular sentiment around how concerning inflation is at the moment and the actions the Fed has, or in this case hasn’t yet, taken.
Uneven Recovery Means Uneven Price Inflation
Sectors like travel and hospitality, which have been some of the hardest hit over the past year, we believe are likely to see the sharpest increase, thanks to a combination of depressed prices before the current surge and a limited ability for companies to increase supply relative to other sectors. These sectors would also be expected to see a corresponding decrease over the fall as the summer travel season tapers off and demand eases.
Energy is another sector that is seeing marked inflation after sustaining a significant drop in prices over the past year, as work from home and limited travel depressed demand. We expect this to continue in the short-to- intermediate term. We also expect to see rising prices for other commodities as demand increases as the production of items like consumer goods and housing ramps up. In addition to the spike in demand that sectors like travel and energy are experiencing, some commodities like timber are also seeing prices rising due to limited supply thanks to the impact of the COVID-19 pandemic and environmental factors on production in 2020 and early 2021.1 In some cases, supply and demand are beginning to balance out and allow prices to settle back down.
12-month Percentage Change, Consumer Price Index, Selected Categories, May 2021
It’s important to remember that because the economy slowed so significantly in 2020, inflation numbers in 2021 are inherently going to appear inflated as the economy rebounds. Over this spring and summer, when measuring change in any economic indicator, we’ll be comparing to the lowest trough of the pandemic. This context is helpful both to understand why inflation may appear so concerning and why many, including the Federal Reserve, are taking a conservative approach in reacting to what they believe is a short-term spike. The predicted year-end inflation rate currently stands at around 2.5%, slightly higher than the typical 2% target set by the Fed but balanced out by recent years in which we did not hit that 2% mark.2
Sustained High Inflation Does Not Seem Likely
While we cannot be certain that inflation won’t spike further over the next several months without then leveling off, the factors that are primarily driving the current increase are in all likelihood not sustainable. Pent-up demand and suppressed supply as a result of the pandemic will level off as many of us are lucky enough to enjoy our summer holidays and return to something closer to our pre-pandemic normal. In areas where, sadly, the coronavirus continues to spread relatively unchecked, demand will remain depressed globally for many of the goods that are causing the recent rise in prices, allowing pricing to settle once the current demand spike from U.S. purchasers resolves.
Part of the increased demand leading to inflation at the moment is also the result of the fiscal stimulus putting money in the pockets of lower- and middle-income households. That is limited by definition, so while it may contribute to spending this summer, that money will run out and Congress has thus far indicated little appetite for further stimulus. We also expect that the accommodating monetary policy of the past year will tail off and that the Fed will make adjustments to corral inflation later in the year if it for some reason inflation does stay significantly above their target rate.
The rapid adoption of technology and the shift to a digital workforce also gives businesses a cost-cutting opportunity that can help keep prices under control, though this is an open question as to what degree these savings would be passed on to consumers and to what degree they would be directed towards shareholders.
Long-Term Portfolios Are Built to Withstand Inflation
Because it is a normal part of market behavior, we assume inflation is going to occur at roughly historical averages over the long term when constructing portfolios. Short-term spikes in inflation, even if quite pronounced for a period, will generally be balanced out by periods of lower inflation over a long enough period.
Since we seek to design our portfolios to withstand a certain level of inflation, our long-term focus will remain steady should we see a further spike in the coming months and we would be looking at changes primarily on the margins to account for a period of sustained high inflation. As discussed in our first quarter market overview, we have already adjusted our typical allocation to fixed income to account for the low returns given the current economic environment, shifting to real assets while maintaining our equity exposure. Real assets historically represent a reliable hedge against inflation, which is why they are included in many portfolios regardless of the current rate of inflation. Because real assets are tied to tangible items with intrinsic value, like physical commodities, natural resources or real estate, their performance is much less closely correlated to economic growth than the performance of equities in particular. As a result, their value tends to be more stable while still providing growth opportunities rather than simply maintaining assets in cash.
A long-term investment strategy means that we are concerned not only with economic and market performance now, but also the time horizon of our clients’ investments. We will continue to make appropriate adjustments as we move through the economic recovery in accordance with our long-term strategies. Your Wetherby team is always available and happy to discuss the specifics of your portfolio.
1 Vox. “Lumber mania is sweeping North America.” May 3, 2021. <https://www.vox.com/22410713/lumber-prices-shortage>
2 Reuters. “Fed’s Bullard sees inflation at 2.5% this year, easing only slightly in 2022.” March 23, 2021. < https://www.reuters.com/article/us-usa-fed-bullard/feds-bullard-sees-inflation-at-2-5-this-year-easing-only-slightly-in-2022-idUSKBN2BF30M>