Key Considerations Regarding Inflation

Published 07/09/2021

In varying degrees, U.S. and foreign economies are beginning to “open back up” as vaccines against the coronavirus continue to be administered. Through the first six months of the year, stocks were up 14.3% (as proxied by the Russell 3000 Index) and long-term Treasury bonds (as proxied by the iShares 20+ Year Treasury Bond ETF) remain down (7.9%) as long-term rates rose to begin the year but have begun trending down over the last few months.

 

Inflation also crept into the headlines with the consumer price index rising 5.0% year over year from May 2020 to May 2021, or 3.8% when excluding food and energy costs.1 Most headline articles, though, fail to mention that inflation expectations are still under 2.5% over the next five years.2 Rather than focus on headlines, we want to detail how to think about inflation as it pertains to your life and your portfolio.

 

Inflation is always a risk factor in investing — it essentially measures the erosion of how much your wealth can buy. Said another way, if the prices of goods and services increase over time, it requires more dollars to consume them.

 

A quart of milk in 1919 cost $0.16. In 2019, the same amount purchased less than half a pint of milk. In 1996, $2.75 would buy a gallon of milk while the current average cost hovers around $3.50. Traditionally, cost of living increases address this and most investments have far exceeded it. When saving for financial goals or retirement, this element of inflation is one nearly everyone grapples with and would like to control.

 

But we can only control what we can control. We believe in investing for the long term and that markets are efficient. In this context, sudden jumps in unexpected inflation affect individuals currently spending a large portion of their wealth, while long-term inflation erodes wealth held in cash or investments that may not keep up with inflation. Let us dive in a bit deeper.


Key Considerations Regarding Inflation for People in the Job Market

·        Continue to save if you have been saving into your investment accounts or qualified plans

·        Invest in things like stocks, diversified bonds whose expected returns exceed inflation expectations over the long term

·        Lock in lower interest rates for your debts through refinancing — mortgage rates remain below pre-pandemic levels

·        If prices do increase, wages may increase naturally or those employed should feel empowered to ask for bigger raises

 

Key Considerations Regarding Inflation for Those Who Are in or Approaching Retirement

·        Social Security is indexed to the consumer price index — the key inflation gauge. This is why we often recommend delaying Social Security if possible because getting the largest payout and having it be inflation protected provides a lot of protection against unexpected inflation.

·        When thinking about inflation in the context of your portfolio, keep top of mind these concepts about its relative impact on your near-term and long-term spending:


1.      For near-term spending that will happen within 10 years, in most cases, you do not need to directly hedge inflation. All short- to intermediate-term bond funds provide reasonable protection against inflation for near-term spending because the dividends and maturing bonds are reinvested at the higher interest rates that typically accompany inflation. Furthermore, inflation is something that slowly saps spending power when compounded over long periods of time. Over short periods, it has less chance to do so.

2.       Next, talk with your financial advisor about your financial plan and make sure you have an appropriate amount allocated toward equities and bonds. The equity allocation acts as the engine that drives midterm and long-term spending. Equities have consistently exceeded inflation over 10-year periods, whereas seemingly safe things like savings accounts or short-term Treasury bonds are much more likely to lag behind inflation, potentially for decades at a time.

3.       For portfolios where a significant portion of midterm to long-term spending has already been allocated to bonds, which would be the case in very conservative portfolios that hold 50% or less in equities, we go one step further and allocate a portion of the bonds to inflation-protected bond funds to directly combat the compounding of inflation over time.

4.       In mostly equity portfolios, an investor’s first priority should not be to directly hedge the bond portion of the portfolio against inflation. In these portfolios, the equity allocation is expected to generate the real returns needed to supply your spending through the midterm to the long term. The two primary purposes of the bond allocation are to provide for near-term spending needs and to diversify equities. Inflation-protected bond funds, when compared to regular bonds, tend to go up and down more so with equities, so using inflation-protected bond funds can reduce the diversification benefit of the bond allocation. 

Hedges for Inflation

Many things touted as hedges for inflation have not been great hedges in the short term. Interestingly, the monthly correlation between the consumer price index and gold spot price since 1970 has only been 0.1, which means it is not a very good direct hedge. Stocks and real estate are not any better. None of them are actually true hedges in the short term. For retirees spending down their portfolio rapidly or others who expect a disproportionate amount of near-term spending, the logical answer remains inflation-protected bond funds.

Stocks do have one big advantage over the others, they compound because companies produce goods and services worth more than the input costs. Those get reinvested and compound. That is the power of stocks that investments like gold do not have over the long term. They intrinsically grow. Real estate is a bit better than gold, but after repairs, rental gaps and building depreciation, its intrinsic growth is low. Its real power has been cheap leverage. It is worth noting that companies benefit from low interest rates on their liabilities, so there is leverage within stocks, too.

 

Inflation remains one consideration among many when looking at your portfolio. If you find yourself worried about its implications, talk with your financial advisor about how inflation could affect your long-term financial plan. 

 

 

Sources

1 “Consumer Price Index — May 2021.” Bureau of Labor Statistics, U.S. Department of Labor, June 10, 2021.

2 “5-Year Breakeven Inflation Rate [T5YIE].” Retrieved From FRED, Federal Reserve Bank of St. Louis. Accessed June 30, 2021. 


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