Consumer prices have gone up across the board. America is reopening, and it seems that many things cost a lot more than they did a year or two ago. With the price increases, you have probably seen the scary headlines about the new inflation concerns.
What should investors do if they are fearful that inflation will stick along longer than expected? There are a few ways investors can better position themselves.
Before we answer that, let’s cover a few definitions.
- Inflation: Occurs when prices rise, decreasing the purchasing power of your dollars.
- Transitory Inflation: The idea that inflation is real but only temporary in nature.
- Deflation: General decline in prices for goods and services. During deflation, the purchasing power of currency rises over time.
- Hyperinflation: Rapid increase of prices in an economy. Typically growing more than 50% per month.
- Stagflation: Characterized by slow economic growth and relatively high unemployment, or economic stagnation, which is at the same time accompanied by rising prices (inflation)
- Disinflation: Still inflation, but decline. One year inflation is 4%, the next 3%, for example.
- Purchasing Power: The value of a currency expressed in terms of the number of goods or service that one unit of money can buy.
- The Fed: The Federal Reserve system is the central bank of the United States and arguable the most powerful financial institution in the world. The current chairman is Jerome Powell.
- 3 Month Treasury Bill: Yield received for investing in a government issued treasury security that has a maturity of 3 months. Often used as the risk-free rate of return for US investors.
Causes for Recent Inflation
Now that we have covered the basics, we can go into what has caused the recent inflation.
1. America Reopened
All the pent-up demand that is being unleashed as the world opens back up. People are eager to spend and get back to their normal pre Covid life.
2. Logistic Issues
Currently, there is a global shortage of computer chips. The work from home demand for laptops and monitors led to semiconductors to making chips for vehicles to personal electronics. Also, many factories were shut down during Covid and are now trying to get back to full scale production.
3. Too much money
The Fed stepped up in a big way during the pandemic. Bailing out corporations, businesses and even stimulus checks for everyone else. All while keeping interest rates very low. Allowing people to finance everything at low rates, from homes to cars.
Let’s not forget the Fed considers some inflation good for the economy. When inflation is too high, the Fed typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Fed typically cuts interest rates to stimulate the economy. The Fed targets a 2 percent inflation rate and the ultimate goal is to keep prices from rising or falling to quickly.
Long term Implications
What should investors do going forward? Eventually the logistics situation will work itself out and the pent-up demand will subside. But don’t expect inflation to go away, the Federal Reserve will continue to target 2 percent inflation.
What does well? The asset classes that have historically performed the best are stocks and real estate. Stocks have historically been a great hedge to beat inflation over the long run. Think of it this way: If every ingredient to make your Big Mac went up in price, then eventually McDonalds will charge you more for the Big Mac. Ultimately the stock price will reflect the higher prices long term.
Same goes for real estate. Right now, the cost of lumber has exploded, and it is one of the factors that have helped fuel the rise in real estate prices. If all the materials for buildings cost more, the price they charge for the house will be more.
Another strategy to help mitigate inflation is by investing in TIPS. The principal amount on these government bonds goes up with the rate of inflation (or decrease with deflation). TIPS generally work best for unexpected inflation. Not a bad option for a more conservative investor.
What does poorly? Cash. When everything goes up in price and you earn nothing on your cash you lose purchasing power. Keeping money in cash is great for short term needs because you don’t have to worry about short term fluctuations. As you can see in the chart below, cash has historically been a bad place for money long term (3-month treasury bill is used as proxy for cash).
Inflation is always something you need to worry about as an investor. One of the main goals of investing is to keep up or outpace the rising cost of living.
The goal of investors should remain to keep enough conservative investments to cover short term income needs and invest long term money in assets that have historically outpaced inflation. That starts with finding a portfolio and financial plan that is best suited for you. The investments in your portfolio should match your needs and goals.
If you are concerned about your own portfolio and the long-term impacts of inflation, reach out. We’re here to help.
Disclaimers and Sources:
Stock investing includes risks, including fluctuating prices and loss or principal. This information is not intended to provide specific advice or recommendations about any stock nor is it intended to be a recommendation to buy, sell or hold any stock investment. We suggest speaking with your financial professional about your situation prior to investing.
Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy ensures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. The Standard & Poor’s Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Investments in real estate may be subject to a higher degree of marker risk because of concentration in a specific industry, sector, or geographical sector. Other risks can include, but are not limited to, declines in the value of real estate, potential illiquidity, risks related to general and economic conditions, stage of development, and defaults by borrower. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.Treasury Inflation-Protected Securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes them more sensitive to price declines associated with higher interest rates.
- Purchasing Power: https://www.investopedia.com/terms/p/purchasingpower.asp
- The Fed: https://www.investopedia.com/terms/f/federalreservesystem.asp
- Commodities and short-term TIPS help combat unexpected inflation: https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvResCommoditiesSTTIPS
- Deflation: https://www.investopedia.com/terms/d/deflation.asp
- Chart: Odds of Cash Outperforming S&P 500. Total Return, 1928-2020. Using 3-month Treasury Bills as a proxy for cash.
- Hyperinflation: https://www.investopedia.com/terms/h/hyperinflation.asp
- Stagflation: https://www.investopedia.com/terms/s/stagflation.asp