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What About Inflation?

Jim Williams

We have heard and seen a good bit about inflation lately.  Inflation is the circumstance wherein the prices for goods and services increase (are inflated) over time.  A modest general inflation rate is mostly seen as a stabilizing force in the economy and is likely a consequence of an ever-increasing money supply which may be necessary to accommodate an ever-growing economy.

 As the economy emerges from the effects of lockdowns and restrictions, the economic damages caused by those actions are becoming manifest.  The labor shortages.  Note that few restaurants are operating at "full capacity" since they are unable to attract and retain workers.  This seems to be true across the service sector, and in other sectors as well.  The number of "help wanted", "we are hiring" signs visible is astounding.  The labor shortage also shows up in other sectors such as the housing and automobile sectors, primarily manifest in the supply chains but also at the point of production.   Try to buy a house or a car these days; there are no bargains.  In case you are not sure if the act of waiting tables or washing dishes in a restaurant is part of "the economy", be assured, it is.

 It seems that one of the largest factors in inflation now is the presence of supply chain stoppages.  For example, the production of new automobiles is severely hampered by the unavailability of certain electronic processor chips.  It is difficult to imagine how deep and wide the supply chain is for these micro-miniature gadgets, but I think it is reasonable to think that it is orders of magnitude greater than the supply chain for a restaurant.  It seems to illustrate the notion that it is pretty easy to cause an enterprise to stop producing.  To get the enterprise back into production is a different kettle of fish.

 A reduction in supply (reduced production – see above) with no change in demand means higher prices.  An increase in demand (increased consumption – see below) with no change in supply means higher prices.  It is hardly surprising that rising prices have appeared in the marketplace.  However, the power of markets can bring these prices back to rational fairly quickly.   For example, this from tradingeconomics.com about lumber prices:

"Lumber futures remained near $500 per thousand board feet in the third week of July, the lowest in a year, as demand continues to slow while mill production has rebounded as the labor-related issues from COVID dissipate. Vaccinated Americans started to travel and book holidays as more businesses and activities reopen instead of spending on home renovations. Lumber prices jumped more than 500% between April 2020 and May 2021 to hit an all-time high of almost $1,700 on May 7th, as sawmills were unable to meet unexceptional demand for home building and DIY home improvements spurred by the coronavirus lockdowns." 

Left to operate rationally, markets will bring about price stability and rationality.  They just do.  

Inflation concerns have also been prompted by the prospect of several trillion dollars of federal spending being injected into the economy.  This is a classic prescription for inflation.  More dollars chasing the same or fewer goods and services.  It seems rational to expect that these dollars will be felt in the economy over a period of years rather than all landing at once when the enacting legislation is signed.  That is, the effects of inflation from this event may be somewhat averaged-in over time.

The responsibility of managing the money supply and consequently inflation falls to the Federal Reserve.  A fairly direct estimate of inflation expectations in the bond market is the Federal Reserve's 10 Year Breakeven Inflation Rate (from fred.stlouisfed.org) which stands now (late July 2021) at about 2.35%.  Again, this is a modest rate and is less than we typically use in our financial planning scenarios.  Others simply watch the 10-year treasury yield which is seen as a fairly competent indicator of longer-term inflation expectations.  Just this month (July 2021) the 10-year treasury yield reached a 5-month low of 1.16%, and at this writing stands at about 1.28%.  That is, the yield you can expect by purchasing a 10-year Treasury bond is 1.28% per year.  This yield is market-driven and does not seem to show an expectation in the sensitive bond market of massive inflation.

There have been deflationary (anti-inflation if you will) forces present in the economy for the past several years.  Increasing automation, improving technology, declining costs for technology hardware, the movement towards a service economy and away from manufacturing.  These are long term persistent trends.  That is, these trends are still present in the economy.  As always, it is prudent to be alert to the incidence and effects of inflation.  Nothing new here.  Further, the fact that inflation has been so moderate in the prior several years does not mean that inflation is a non-issue; nor is this writing to be interpreted to mean that we expect inflation to remain negligible.  We must expect that there will be outsized inflationary pressures from time to time and for periods of time.  This may be the time.

As with any aspect of financial uncertainty, the market presents a panoply of remedies (many of which have high costs and high commissions) for the feared inflation, including Energy Stocks and Commodities, gold, Bitcoin, and Treasury Inflation Protected Securities (TIPS).   Asset nominal returns for Energy Stocks and Commodities in the last 30 years have been multiples more volatile than inflation itself.  That is, the potential benefits of these asset classes as inflation hedges are weak and the cost in terms of increased portfolio volatility is very high, making these poor choices to shield the portfolio from the effects of inflation.   We have never liked gold as an investment, and as for cryptocurrencies, well, leave that for another day, but there is no there, there.

 There are TIPS funds that will provide exposure to inflation protected securities and this strategy is, at least, rational, but read on.  Note that at this writing, the Vanguard and DFA offerings of TIPS funds have NEGATIVE yields of between 1% and 2%.  That means you are happily paying the treasury 1% to 2% of your principle each year for the service of holding your money, in the hopes that inflation zooms, and you will reap the reward.  For us, it makes more sense just to hold equities in the proportions decided upon in arriving at the asset allocation described in your own personal investment policy.  We believe that staying invested may be the most effective long-term solution to concerns about inflation. 

Here is the big question.  Does it make sense to disrupt a well-designed and well-thought-out investment strategy; one which is explicitly designed to absorb and overcome the effects of inflation over the long term, with a different set of risks and premiums which may or may not ultimately be effective against short-term inflation?  Keep in mind that our planning work always has included a robust estimate for inflation (price increases for living costs) over the life of the plan.  Keep in mind that the investment policy you have designed with us is explicitly focused on overcoming the effects of inflation over the long term based on your own personal tolerance for investment risk.  

We have prepared for this exact thing.   Whatever inflation we see may be "worse" or "not-as-bad" as we estimated.   We won't know until it is well in the rear-view mirror and long past the point of making tactical changes in anticipation of the actual incidence of inflation.  Now, no less than any other time, it is important to stick with the program.  Tune out the noise.

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The table below shows the returns through June 30, 2021 for selected investment asset classes.   In most cases, the results below are appropriate benchmarks for the related mutual funds in your investment portfolio.