By Deron McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer
Inflation – What do consumers need to know?
Ahe Consumer Price Index (CPI) came in red hot last month at 4.93%—marking the largest year-over-year increase since the summer of 2008. But if you recall, that brief era marked a time when oil prices were north of $120/barrel. If we strip out those high oil prices, we have to go all the way back to 1991 to see CPI prints in excess of 5%. Even if you alternatively chose to look only at the ‘CPI ex Food and Energy’ (which posted a 3.79% year-over-year increase) it serves to confirm the magnitude of the increase, as it’s the largest posted increase since May of 1992.
Something to keep in mind for the balance of the summer is that here in 2021, annual changes and year-over-year data points all need to come with an asterisk. Why? Well, it was just twelve short months ago that many were afraid to even emerge from their homes. There’s no rocket science required to understand that as the world sheltered in place during the spring and summer of 2020, consumer spending was far from robust. At the time, many were even worried about deflation!
Now, fast forward a year and economies are reopening. Summer vacations are coming alive—with massive amounts of both pent-up energy and pent-up demand. Furthermore, consumers are flush with a massive amount of unprecedented stimulus. We want to have fun!!! And we’ve got the money to do it!
What does it all mean? The year-over-year comparisons make for easy, attention-grabbing headlines; juxtaposing today’s mini euphoria to the dismal gray days of the early pandemic. No wonder the numbers are through the roof!
But fortunately, we can solve data feed errors. By simply comparing current data to pre-pandemic data from two years ago, and repeating for the entirety of the series, we see that the two-year base effects (comps) are much more in line with recent historic norms and less than half of the inflation we saw in the early 1990s.
What’s the takeaway? Current inflation isn’t anywhere close to a repeat of the late 1970s (nor even the early 1990s), but merely a return to normal after the near deflationary experience we all suffered thru in 2020. While we may get some sticker-shock this summer as the globe squeezes two years of demand into two short summer months of supply, prices will tend to return to normal as the economy and society fully returns to normal in 2022.
Even though this inflation isn’t terrifying, it’s still a move higher from the recent past. What effects will it have on individuals and their portfolios?
In 2020, the emphasis was on ‘working from home’ at the expense of ‘having fun’. Therefore, prices for laptops and desks (and home improvement) were the key beneficiaries. But here in 2021, expect prices to run up most in areas tied to leisure and entertainment, as we all seek to reintroduce some fun back into our lives.
Looking further out, expect interest rates to rise even further after already posting a sizeable increase over the last twelve months. Why? As society gets back to normal, we expect markets to get back to normal as well. And a normal functioning bond market (specifically intermediate-term interest rates) entails positive yields after accounting for inflation. In other words, bond yields should be higher than inflation prints. Also, monetary policy (short-term interest rates) should follow along and move higher as well. While it might be a bit premature this year, perhaps in late 2022 or 2023 investors can expect some modest levels of income on both bank accounts and money markets, with subsequent annual increases thereafter.
But on this path back to normal, investments tied to current levels of interest rates might suffer some setbacks. Unlike your mortgage where locking in today’s low rate for 30-years might make sense, locking in today’s low rate for a 30-year investment certainly doesn’t. Instead, investors will want to use shorter dated bonds that will be able to mature in that higher interest rate environment in order to repurchase and lock in the then higher level of rates. Or better yet, own bonds today that have a floating coupon which will ratchet higher in the years ahead.
Outside the bond market, consider seeking out investments that do well in a higher inflationary environment. Commodities and commodity stocks (i.e., natural resource equities typically found in the Energy and Materials sectors) tend to do well. The machinery (typically found in the Industrials sector) needed to mine those commodities should also benefit. Additionally, financials and bank stocks should continue to outperform since the sector is most closely correlated to higher interest rates. These four sector stalwarts dominate the Value index—so perhaps look for the next leg of the cycle to reward these names rather than the dominant themes of the last cycle—namely Growth, Technology and FANG+.
While betting against the dominance of Apple, Microsoft, Google, and Amazon seems like a fool’s errand, it’s this exact dominance that might put those firms in the crosshairs of Washington D.C. But no matter the political outlook, the inflation and monetary outlook argues for at least a balanced approach to your asset allocation for the next leg of the business cycle.
The information contained herein is for informational purposes only and should not be considered investment advice or a recommendation to buy, hold, or sell any types of securities. The information contained herein was carefully compiled from sources SEIA believes to be reliable, but we cannot warrant or guarantee the accuracy or completeness of the information provided. SEIA is not responsible for the consequences of any decisions or actions taken as a result of the information provided herein. Financial markets are volatile and all types of investment vehicles, including “low-risk” strategies involve investment risk; Past performance does not guarantee future results. Indices and benchmarks referenced herein are unmanaged and cannot be invested in directly. Investment return will be reduced by the investment advisory fees and any other expenses that the client may incur in the management of an investment advisory account. Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors. In general, the bond market is volatile, bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default. The price of commodities is subject to substantial price fluctuations over short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.