As the economy continues to rebound, and as fiscal and monetary stimulus continues, the questions regarding these actions and their effects on inflation are becoming more prevalent. Several economists are now predicting inflation will rise over the course of the next few years, and if true, this will have a significant impact on investor portfolios.
First, let’s begin by discussing what inflation is: It is the decline of purchasing power of a given currency over time. Inflation measures the change in the price of goods and services. Increasing inflation means that costs for goods and services are rising. When costs decline, that is called deflation. Over time, inflation is much more prevalent in growing economies compared to deflation.
The level of inflation, or the inflation rate, is very important to understand. The expectations for inflation can be seen in the chart below, the 10-year breakeven inflation rate. The recent increase (green arrow) shows the market is expecting inflation rates to rise in the future. The latest data point as of 01/15/21 shows a rate of 2.10% (purple circle) a quick reversal from the lows of March 2020 when rates dropped to 0.50% (red circle). This type of collapse and recovery was also seen in the great financial crisis of 2008-09.
Now that we know what inflation is, and what expectations are, let’s look at some of the primary drivers that cause inflation:
- Rapid economic expansion
- Expansion of the money supply through monetary and fiscal policy
- Increasing production costs
The economy is rising after a significant negative shock due to restrictions and shutdowns caused by the coronavirus pandemic. Further, fiscal (government) and monetary (Federal Reserve) policies have increased the money supply creating more dollars in the system to chase the same amount of goods. Lastly, commodity prices have risen, elevating expenses for both individuals and corporations. All these actions, both independently and combined, have the effect of increasing inflation.
Inflation, and the rate of inflation, plays an important role in the economy. Constructive inflation comes from an economic expansion when unemployment is declining while wages are rising. If inflation rises too quickly, however, basic human needs such as food, shelter, and energy costs may surge too abruptly and harm the economy. There is a fine balance between too little and too much inflation. The U.S. Federal Reserve has an inflation target rate of 2% annually, which they feel is an optimal amount to continue economic growth but not overheat.
For investors, inflation is important as well. The consequence of rising inflation is that current assets purchase less in the future (which is called the erosion of purchasing power). Cash held in a bank account provides a clear example. Cash generates little to no return, and if prices are rising, the cash held now purchases fewer goods and services one year from now than it does currently. Therefore, investors need to earn a rate of return that exceeds inflation in order to maintain the same purchasing power over a long period of time.
In the current environment, we expect rising inflation to eventually lead to higher long term interest rates. If interest rates rise, this will have a negative impact on current bond prices. On the other side, potential beneficiaries of rising prices include assets like stocks, real estate, and commodities. Constructive inflation, as discussed above, is a tailwind to these asset classes as their value tends to rise along with rising prices. An overheating economy with prices rising too fast, however, can be detrimental to these asset classes as consumers can no longer afford their goods and services and policymakers must intervene to slow growth. At Gradient, we believe inflation is currently controlled, but we will continue monitoring for signals of an overheated economy. As a result, our stance is that bonds are unattractive right now and stocks, while expensive, could continue to grind higher.