When it comes to inflation, a small amount of it is healthy for the economy. That’s because when consumers and businesses expect prices to continue rising, they are more likely to buy something today. Strong current demand spurs growth on the supply side of the economy since businesses expand their workforces and production to meet this demand. As you can see, low and consistent inflation creates a virtuous cycle that is good for economic growth. In fact, the opposite scenario – deflation – would likely be more problematic than moderate inflation. The US Federal Reserve has set a target of 2% for core inflation with the duel aim of avoiding deflation or high inflation.
As we transition ‘back to normal’ there has been high consumer demand, massive governmental stimulus, supply chain issues, and global shortages of raw and manufactured goods. The Federal Reserve anticipates that most of these inflationary forces will abate. Caught between managing inflation and spurring growth, they’ve emphasized their goal of bringing employment back to pre-pandemic levels. If inflation proves to be less transitory than most economists expect, the Federal Reserve will likely take steps such as raising interest rates to avoid overheating the economy.
Inflation becomes dangerous when it causes too much growth and prices rise faster than wages, with everyone worse off in terms of purchasing power. To help counteract this effect for many retirees, the Social Security Administration bumped benefits for 2022 by 5.9% (compared to an annual average adjustment of 1.65% over the last decade)! For wage earners, incomes have and should continue to rise. So, for most clients there is a good amount of insulation against inflation via higher cash inflows. We also recommend appropriate cash reserves since cash is very susceptible to inflation. The inflation-adjusted ‘return’ of cash is virtually guaranteed to be negative. The risk of losing purchasing power can be mitigated through long-term, thoughtful investments and cash flow planning.
When it comes to the portfolio, we’ve designed the investment allocations with risks – like inflation – in mind.
- Stocks typically hold up well against inflation in the long-term because companies can pass higher costs along to consumers. The bulk of most client portfolios are invested in US, developed international, and emerging market equities.
- Bond returns may be muted or negative on a “real” (inflation-adjusted) basis in an inflationary scenario. This is especially true if interest rates rise – which is likely if the Federal Reserve deems it necessary to rein in inflation.
- We have positioned portfolios with a healthy allocation to short-term bonds to diminish this risk. Shorter maturity bonds are less impacted by rising interest rates because they mature more frequently and can reinvest into higher interest rates.
- We also avoid any allocation to long-term bonds right now because those would be most significantly hurt by rising interest rates. Yields at those maturities are not compelling enough for this large risk.
- Commodities and real estate are “hard assets” that should do well in an inflationary scenario.
- Real estate investments provide a hedge due to land scarcity and because rents tend to adjust with inflation, providing income protection.
- Commodities have been the best performing asset class this year in part due to inflationary factors. While a laggard in the low yield and low inflation environment of the late 2010s, commodity funds have done well as an investment because prices for goods as far ranging as copper, lumber, and crude oil have all risen considerably this year.
No one knows which portfolio risk will present itself next, so we want to stress the importance of remaining diversified and disciplined in achieving long-term investing success. If you have any questions or concerns about the positioning of your portfolio, let’s discuss it at your earliest convenience.
