Updated: Jun 8, 2021
For those of us who remember the 1970s, you would be forgiven for feeling a twinge of déjà vu in recent weeks. Here in the Southeast U.S., we saw gas shortages and long lines at the pump, albeit due to the very modern problem of a cyberattack by a foreign criminal gang rather than the whims of OPEC. Couple that with headlines trumpeting the return of rising inflation, and you may find yourself unwillingly digging in your closet for those old pair of bellbottoms. While this gas shortage was thankfully short‐lived (after the Colonial Pipeline paid $4.4 million in ransom money to Russian hackers), we can’t be so sure about the staying power of inflation. On the surface, the numbers do look quite alarming – prices for consumer goods, represented by the Consumer Price Index (“CPI”), jumped 0.8% in the month of April, the largest monthly increase in over a decade. On an annual basis, CPI rose 4.2% – the largest 12‐month increase since September 2008.
Inflation, while simple in concept, is actually quite a complicated thing to gauge – its effects can be narrow or widespread, temporary or long‐lasting, a sign of a healthy economy or a cause for concern. In this letter, we will tackle some of the basics, examine the current context of rising prices, discuss the impacts of inflation on an investment portfolio and strategies to mitigate the risk.
Is inflation always bad? Economists define inflation as the decline in purchasing power of a particular currency. The effect of this can be measured by the rise of prices over time because in an inflationary environment, a fixed amount of dollars will buy less of a given good or service. In other words, inflation simply means that your dollar just doesn’t go as far as it used to. However, some modest inflationary pressure is actually a sign of a healthy economy. Why? Because, theoretically, in a growing economy where there is an increased demand for workers, wages will rise. More money in pockets increases demand for goods and services, causing prices to rise as well. Not factoring in gains in productivity or efficiency, wages and prices should both modestly tick up as the economy expands. In fact, the Federal Reserve’s inflation target is not zero, but 2% annually (to be precise, the Fed targets core inflation, which excludes the more volatile food and energy sectors). In reality, the U.S. economy has consistently run below that level for several decades. As shown in Figure 1, since the Global Financial Crisis, actual inflation has lagged well behind the Fed’s 2% target – a sign of stagnant wages and sluggish economic growth despite periods of historically low unemployment.
The pandemic and benign inflation. The 4.2% year‐over‐year increase in CPI reported in April was dramatic – over double the Fed’s target rate. But does it signal the beginning of harmful, runaway inflation that will outpace wages and dampen the value of the U.S. dollar? Not necessarily. To start, the past 12+ months have been extraordinary and unprecedented, in both human and economic terms. As COVID‐19 began to spread in March 2020, the economy shut down virtually overnight, closing businesses, disrupting supply chains and grinding manufacturing to a halt. As a result, the prices of goods plummeted across the economy, impacting everything from gasoline, to airline tickets, to women’s dresses (because retailers were forced to offer steep discounts as inventory piled up in un‐trafficked stores). For this reason, the change in CPI from the spring of 2020 to the spring 2021 will be unusually large simply because of depressed prices last year (see Figure 2). Neil Irwin, writing in his January 16 The Upshot column in The New York Times calls this the “yo‐yo effect.” Using women’s dresses as an example, Mr. Irwin points out that on paper, prices are on track to be nearly 18% higher than they were at this time last year – even so, they would still be 9% below their pre‐pandemic levels. In fact, in August 2020, partly in anticipation of the yo‐yo effect, but mostly in recognition of years of persistently low inflation, the Fed reframed its inflation target from 2% annually to a 2% average over the long term, thus allowing for periods of higher inflation in certain economic conditions.
Another pandemic‐related, and potentially temporary, spike in prices can be explained by what Mr. Irwin calls “the end of hibernation.” Like a ravenous bear emerging from a long winter’s nap, the public’s increased appetite to travel, shop in stores and eat out after a year of abstention may cause abnormally high demand. Couple that with decreased supply and the laws of economics dictate an increase in prices. Additionally, retailers may be tempted to raise prices to make up for lost revenues in the pandemic. These effects may not only impact things like rental cars or hotel rooms, but also less obvious things like dress pants as people ditch their sweatpants and return to office life. These kind of price changes, due to typical market forces like supply and demand, are actually a sign of a recovering economy and not necessarily a warning sign of impending runaway inflation.
The risk of too much liquidity. A riskier form of inflation may result from the current glut of accumulated savings. For those fortunate enough to be able shift to remote work and maintain their income level throughout the pandemic, saving money became easier with typical splurges such as dining out or taking vacations off the table. This led to a huge increase in household savings – Americans saved $1.56 trillion more from March through November 2020 than they did over the same period in 2019. And that was before two additional rounds of government payments at the end of 2020 and earlier this year. As such, total U.S. savings on deposit have exploded to nearly $11 trillion (see Figure 3) – if everyone spent that money at once, supply may not meet demand. Unlike the “end of hibernation,” this effect would not only be focused on industries impacted by the pandemic, but would be widespread, pushing prices higher across the economy.
Many economists believe that stimulus is just what is needed following years of stagnant growth and last year’s economic contraction. If the economy can absorb the increased demand through a corresponding increase in supply, rising prices would be offset by more factories, more jobs, and higher wages. However, the danger lies in the risk of starting a self-fulfilling cycle where businesses and consumers start anticipating higher prices – this fuels demand even more as consumers look to buy goods before prices rise further, resulting in higher prices, and so on, and so on. This spiraling cycle, or hyperinflation, can wipe away the positive effects of economic stimulus. In fact, the inflationary environment of the 1970s was preceded in the 1960s by a period similar to today, with increased government spending and a rise in incomes.
Global inflationary trends. The pandemic and the U.S. government’s reaction have created an environment that risks sparking a liquidity‐fueled period of runaway inflation, but those are not the only dangers. Global macroeconomic trends, some related to the pandemic, some geopolitical, and others demographic, pose longer‐term threats. As mentioned above, the U.S. (along with other developed nations) has experienced a period of low inflation for three decades, marked by muted growth and falling interest rates. Economists are not exactly sure why, but a contributing factor may be the huge influx of cheap global labor, particularly from China, that has tamped down wages in developed economies. This global pool of inexpensive labor is expected to shrink in coming years for a variety of reasons. For one, the growth of China’s more educated middle class has raised wages in the country. Additionally, the legacy of China’s “one child” policy has created a future demographic crisis with a decreasing population that will lack enough working‐age people to sustain the aging majority. Developed economies are seeing similar demographic trends with populations increasingly skewing older. Combine a shrinking working‐age population (see Figure 4) with a shortage of inexpensive labor, and the result may be a world with too few workers, putting upward pressure on wages. Other catalysts for inflation loom as well, such as trends away from globalization (e.g., increased tariffs, populist movements like Brexit, etc.), widespread deficit spending and growing global debt, and a weakening dollar that may no longer hold its place as the world’s reserve currency (see our 2Q2020 letter for more on this topic).
The impacts on bonds and stocks. As discussed in our 3Q2020 letter, with bond yields at historic lows, it is very unlikely that total bond returns (including income) will be able to keep pace with inflation in the nearer term. The effect on stocks is more complicated. Because a company’s revenue and profit can rise with inflation, in theory stocks should have some inflation hedging qualities. However, not all stocks will perform this way. Growth stocks, particularly from companies that lack pricing power, may underperform value stocks during periods of high inflation because the value of future earnings (which investors in growth stocks are betting on) will be less. Also, for U.S. investors, non‐U.S. stocks become more attractive as the dollar weakens and investors earn a return on foreign currency. Overall, the uncertainty associated with rising inflation can result in more stock market volatility, an environment that can reward skilled active investment managers.
Inflation‐hedging investments. Because inflation and inflation forecasting are extremely complex topics, building a portfolio that can weather, or even benefit from, rising inflation is also complex. We will save a deeper dive into the topic of inflation‐sensitive investments for future conversations; however, for this letter’s purpose, we will describe what makes an asset “inflation hedging” and discuss a few investments that can fit the bill.
In the investment world, so called “real assets” are assets that hedge against rising inflation. Hedging in this context really means that the investment will rise in value alongside inflation. Real assets are “real” in the sense that they are not financial assets (e.g., stocks and bonds) or intangible assets (e.g., patents, intellectual property, and brand recognition). Instead, they have some stable intrinsic value due to limited supply, a lack of substitutes and stable utility (think “real” estate). Additionally, they may be priced globally, independent of any particular currency. Gold is a classic example of such an asset – when inflation rises and the dollar declines in value, the amount of dollars it takes to buy an ounce of gold will increase. Other real assets, such as oil, have seen their intrinsic value become less stable as substitutes like wind and solar emerge and the world moves away from fossil fuels due to their environmental and social costs.
Inflation‐hedging investments also include assets with inflation‐sensitive rents or contracts. For example, apartment buildings typically have leases that allow rents to rise annually with inflation. Infrastructure assets like toll roads, utilities, and railroads typically feature contracts that can also rise with inflation.
The path forward. As discussed above, we see little doubt that inflation will rise in the near‐term as the result of the unusual economic conditions in 2020 and 2021; however, we also believe that the longer-term threat is real. A weakening U.S. dollar, massive government debt, a significant increase in the money supply, a decline in global cheap labor, trends towards de‐globalization – these are all factors that could usher in an era of higher inflation. As a result, we believe an increased exposure to real assets including real estate, and public and private infrastructure (toll roads, utilities, etc.) is prudent. In addition to their inflation‐hedging qualities, the income generation associated with some of the investments can serve as a higher‐yielding source of income than lower‐yielding bonds. Finally, we are maintaining diversified currency exposure to hedge against the decline of the U.S. dollar.
2021 Virtual Client Conference Update. In lieu of an in-person client conference this year, we’ve held two virtual sessions: The Market “De‐FAANGed” – An Interview with Gil Simon of SoMa Equity Partners and Value Investing: Is Cheaper Better? – An Interview with Silchester International Investors. If you would like to see a replay of either webinar, please email Joel Streeter (firstname.lastname@example.org). Details regarding our next virtual client conference session will be announced soon!
As always, we hope you remain healthy and safe. We would love to hear from you and welcome conversation – please reach out to us anytime you would like to chat.
The Mangham Associates Team
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