INFLATION: IT’S BACK
The May release of the Bureau of Labor Statistics’ inflation data was an eye opener: the benchmark “CPI-U”, or the Consumer Price Index for All Urban Consumers, was up 5% year-over-year – a substantial increase over the 1.8% average we have seen over the past decade. It was a wake-up call that inflation might be back in our lives and led many investors to worry about their portfolio and what they should do to counteract this.
Inflation is the tendency for a price of a good or service to rise over time. Or to put it another way, it is erosion of the ability of $1 to buy you the same quantity of a product over time. For example, in 1941, $1 would buy you 3 pounds of top sirloin; at current prices, now $1 buys you less than 1/3rd a pound of beef – a 90% reduction in the dollar’s purchasing power.
Hence, it is why we do not recommend clients hold large amounts of cash for long periods of time: if you kept your money under the proverbial mattress, it would buy less and less goods over time. And it is one of the reasons we tell clients to invest for “real” or after inflation growth in their portfolio and that they need to take some market risk to accomplish this.
Without risk, investors will get no real growth and their long-term purchasing power will decline over time. The following chart shows the long-term implication, in relative terms, of keeping your money under the mattress (i.e., keeping it in cash) versus lower risk US treasury bills (i.e., very short-term US government debt), commercial paper (i.e., very short term, low risk corporate debt) and US stocks (relatively higher risk).
We advise that inflation is, in many ways, the most significant macroeconomic risk faced by those who are in retirement or making long term plans. Indeed, over an extended period, it can become a hidden risk factor in how it can permanently destroy wealth in a slow way. It is like the way wind and water erode rocks over time; it is hard to notice at any given moment but over time its impact is profound.
IS IT HERE TO STAY?
All of this brings us to the question of how likely are we to be entering a new and sustained period of high inflation? Will we be entering back into a period of high inflation like we saw in the 1970s when inflation peaked out at 13%? Or will we see prices trend back to the low average rates we have seen since the 1990s?
The short answer is that it is likely we will not see a sustained surge in inflation over the coming years. It is our opinion that much of the increase we are now experiencing has more to do with supply chain disruption and lifestyle adjustments caused by the Covid-19 pandemic than a more systemic or long-term cyclical change.
THE PANDEMIC WHIPSAW
Over the past year and a quarter, prices on a number of goods and services have bounced around in dramatic fashion. The price of gas fell from a national average of $2.66 per gallon in January 2020, to $1.87 in April, and then 15 months later it stands at $3.20. All of this makes sense as consumers were literally on lockdown a year ago but have now raced to hit the road now that restrictions across the country have been lifted.
Likewise, lumber went from $460 per 1,000 board feet in January 2020, down to $256 in April, and then spiked to almost $1,700 towards the end of 2020 before settling down to its current price of $700. Much of this was attributed to the compound effect of households spending money during the pandemic on home improvements (rather than on things like travel) and mills reducing capacity in reaction to the initial market decline. They have then been slow to re-engage capacity for fear of over committing financially.
Global disruptions were experienced in the factory supply chain, and this compounded the shortages seen in many goods. Factories in China, Taiwan, Korea and other parts of Asia, the source of so much of our on-demand economy, shut or slowed down due to their own national lockdowns. This came at the same time as demand surged for electronics of all types: new laptops and home networking equipment for students or parents working from home, Peloton exercise bikes, etc. The weak links in the global supply chain were exposed – whole assembly lines for cars were held idle as the availability of computer chips became scarce.
In short, the pandemic created a disjointed and disrupted economy at home and across the globe. To our system’s credit, it was able to adjust, for the most part, to meet both the most basic needs (toilet paper shortages notwithstanding) and to find a way to create new markets and meet new needs for consumers. But market economies, while remarkably flexible and robust, cannot pivot on short notice when it comes to restarting and rebuilding. So, it is likely we will have to endure ongoing pandemic related price increases for the foreseeable future.
However, factories that were shut down or running on limited production are re-opening or kicking back into higher gear. New ships are being built to meet growing trade demand, airlines are bringing planes out of moth balls, and rental car companies are rebuilding their fleets. All of this takes time to happen, but the impact of the current shortages, and corresponding price increases (inflation) will surely lessen over time.
MARKETS ADJUST AND ADAPT
There are likely to be some areas of the economy where price increases will be normalized for a longer period – but it is difficult to forecast exactly where and how these will manifest themselves. Our portfolios are designed with longer term, real growth in mind and they can adapt to inflationary environments. We still use a base inflation rate of 3% in all of our financial plans (health care and college costs get higher rates) and at this point we continue to believe they are still conservative estimates.
In closing, we believe clients should be aware of the long-term impact of inflation and plan accordingly with our input and guidance. For now, there is no reason to adjust financial plans or portfolio allocations based on the current cycle.