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Understanding Inflation & What To Do About It As An Investor

Inflation is headline news in the US and around the world. Consumers are experiencing price increases on new cars, used cars, housing, food, energy and more. The US Bureau of Labor Statistics reported that the Consumer Price Index (CPI) was up 8.5% in March and 8.3% in April, the highest increases since December 1981. Inflation reduces consumers’ buying power and often generates increases in interest rates, which impact stock and bond markets.THE HIGHEST INFLATION IN A GENERATION

 

To help you make the right decisions in your portfolio, as markets react and alarming headlines abound, gaining a firm understanding of inflation and its implications may prove useful. Here are answers to key questions to help, including: What is inflation? What causes it? How can it be managed? How do markets react to it?

What Is it? Defining Inflation

Inflation is defined as the rate of price increases of goods and services in the economy. In the US, we follow several measures of inflation:

 

CPI

which measures prices for a basket of goods and services over time

CORE CPI

which excludes food and energy, whose prices tend to be more volatile, from the CPI calculation

PRODUCER PRICE INDEX (PPI)

which reports changes in the prices of inputs for US producers (e.g., fuel, commodities)

 

What Causes Inflation?

A variety of factors can cause prices to rise, and we believe that the current inflationary environment is a result of many of those factors acting together:

  • Supply chains remain disrupted, making it more difficult to ship and receive both raw materials and finished If demand stays stable but supply is constrained, prices tend to rise.
  • Increases in demand when supply is relatively constant or constrained can cause prices to The global pandemic changed many shopping and living patterns, which in turn changed demand patterns for a wide range of goods from groceries to housing.
  • The pandemic also put a strain on labor, as many people who left the workforce have chosen to stay out of it, even as the economy More jobs and fewer workers mean that employers need to pay higher wages, which are typically passed on in the form of higher prices.
  • Geopolitical issues, especially the Russia/Ukraine conflict, have put a crimp in the global supply of oil, driving energy prices higher.
  • Fiscal policy can drive inflation, as government spending and subsidies create more demand for goods, services and labor, making them more scarce and consequently more
  • Monetary policy can drive Under some circumstances, when the Federal Reserve takes action to increase the supply of money by reducing interest rates or purchasing bonds, consumers and businesses have more money to spend, and they drive prices higher.

 

MORE JOB OPENINGS THAN UNEMPLOYED WORKERS

“Non-farm” refers to Nonfarm payrolls, the Bureau of Labor Statistic’s measure of the number of workers in the U.S. excluding farm workers and workers in a handful of other job classifications.

“Thous Persons” = thousands of persons “SA” = seasonally adjusted

What Can Be Done To Control Inflation?

Controlling inflation is one of the most important mandates for the Federal Reserve, the central bank of the United States. It has a variety of tools at its disposal, but the most critical ones are the federal funds rate (fed funds rate) and quantitative easing. Both of those tools relate to regulating interest rates.

The fed funds rate is the interest rate that commercial banks use to borrow or lend their reserves overnight. This rate can influence short-term interest rates for credit cards and a variety of different loans. When interest rates are low, borrowing money is inexpensive, and consumers and businesses tend to spend more, driving prices up. When rates go higher, borrowing is more expensive, which tends to slow spending and, in turn, can slow price increases.

Quantitative easing (QE) takes place when the Fed (or any central bank) purchases financial assets — typically bonds but sometimes including stocks — on a large scale. This practice, first employed during the Great Recession, increases the amount of money in circulation, stimulating economic growth, and keeps long-term interest rates low by creating demand for bonds. After employing QE, the central bank may move to quantitative tightening

(QT), when it sells the bonds that it has purchased. This increase in supply should cause an increase in long-term interest rates, which, in turn, slows economic activity and reduces inflation.

The Federal Reserve is employing both of those tools to manage the current inflationary environment in the US. In March, it announced that it would increase the fed funds rate by 25 basis points (abbreviated bps; each basis point is 1/100 of one percent), and in April they announced an additional 50 bps increase — the largest such increase since 2000. With inflation still running high, most economists believe that the Fed will increase the fed funds rate by another 50 bps in June, with additional increases to come depending whether data shows inflation has slowed. In general, the Fed tries to keep inflation in the 2% range — which is dramatically lower than the 8+% that we have seen during the first four months of 2022.

 

How Do the Markets Typically React to Inflation?

STOCKS: Rising prices can benefit earnings of

 

companies, which can pass on increasing costs to their customers and maintain their margins. At the same time, inflation and rising rates make borrowing and investing more expensive for businesses, which may hamper capacity and growth going forward.

According to a recent CNBC article, “When inflation exceeds 7%, the median return of U.S. stocks over the next year was 7.3%, compared to 10.3% when inflation was below 7%. And if we examine every yield curve inversion since August 1978, the median inflation-adjusted return of

U.S. stocks was only 4.7% over the next year, compared to 9% during every other period.”1

“Inflation and rising rates make borrowing and investing more expensive for businesses, which may hamper capacity and growth going forward.”

 

1 Maggiulli, Nick. “Op-ed: Will high inflation hurt stock returns in the long run? Not really,” CNBC, April 5, 2022, retrieved from https:// www. cnbc.com/2022/04/05/high-inflation-wont-really-hurt-stock-returns-in-the-long-run.html on May 13, 2022.

 

BONDS: Does that mean that investors should reduce exposure to equities in favor of Treasuries? Not necessarily.

Bond prices inversely correlate to interest rates, so as rates rise, bond prices go down. Since inflation usually generates higher interest rates, it is typically bad for bonds. We note, though, that while this short-term shock is bad for the market, the higher interest rates paid by bonds can make them more attractive to investors, especially to investors focused on income rather than capital appreciation.

The CNBC article also notes that “when inflation exceeds 7%, the median inflation-adjusted return on five-year US Treasuries was -2.6% over the next year, far below the 7.3% return on US stocks during the same time period. And, following every yield curve inversion since August 1978, the median inflation-adjusted return on five-year US Treasuries was 3.9%, compared to 4.7% for US stocks over the next year.”1

 

Investor Considerations

As discussed above, inflationary periods have historically put pressure on short-term equity returns and on short-term bond returns — and we know that inflation reduces the buying power of cash. So, what should investors do when facing an inflationary environment? Here are some time-tested suggestions:

  • Consider your investment horizon: Conventional wisdom suggests that staying the course usually benefits investors — provided they have an investment horizon that can tolerate short-term Nobel laureates Eugene Fama and Kenneth French, in their famous paper describing their three-factor model, note that investors who can tolerate short-term volatility and who have an investment horizon of 15 years or more are often rewarded for their short-term losses.
  • Have a Plan: Inflation and rising interest rates happen, and a good financial plan anticipates and protects against such Too often, investors without a plan may engage in the “panic trade” and sell indiscriminately when markets are down.
  • Focus on Quality: Rocky market environments often create During turbulent times, we believe it is more important than ever to seek to invest in companies with strong market positions, experienced management teams, strong balance sheets and the ability to generate free cash flow.
  • Most Importantly, talk to your advisor: First and foremost, turbulent markets can be confusing and We suggest investors have frank, open conversations with their financial advisors at all times, and especially during stressed markets when the advisor’s experience provides crucial perspective.

 

-PRIVATE VISTA, EFBC STRATEGIC PARTNER