In our April update we wrote about the potential for an uptick in inflation as the world mounted a rapid recovery post widespread vaccine distribution. Up to that turning point, thanks to record-breaking fiscal support, the U.S. through the pandemic crisis had been able to avoid the most negative and much-feared potential economic outcomes. Thank goodness.
However, that seemingly unlimited fiscal and monetary stimulus seen in the past 14 months will have consequences. We believe part of these consequences will show up in the form of inflation, not runaway like we saw in the ‘70s and ‘80s, but more significant than we have seen in decades. We already see the crystallization of inflation: houses are being bid up to well-above their pre-pandemic values, labor shortages are building, and raw material prices are surging. This will affect the economy, markets, and investments of all kinds.
The U.S. has lived with minimal inflation for 30 years and has not seen the Consumer Price Index (CPI) top 5% since the early 1990s. You have to look back to the early ’80s to see CPI rising above 10%. While we think inflation nearing 10% is unlikely, we believe a base case of a CPI rising 3-4% is reasonable given the current circumstances. Most investors in today’s market have little to no memory of markets in times of inflation. However, our experience tells us positioning your portfolio to at least dull the effects of inflation is wise. To meet this new dynamic, while not making wholesale allocation changes, we have been implementing adjustments to client holdings for the past several months.
A Primer on the Forces of Inflation
We are already hearing alarms ringing. Used car prices are up between 15%-25%, the Dow Jones Commodity Index is up 40% from pre-pandemic levels, and prospective home buyers are seeing rapidly rising prices. But what is actually causing this?
The Demand-Pull
As fear of the virus continues to drop and more people have the desire and means to spend, prices are beginning to rise, especially for discretionary goods. Pent-up demand for travel is real. Pent-up demand for housing is real. In the long term, calls for increased infrastructure spending and the developed world’s green agenda will require massive amounts of government spending. This increase in spending will require further increased supply to avoid inflation. However, we continue to see problems throughout global supply chains and labor supplies, which leads us to the next issue: the cost-push.
The Cost-Push
At the beginning of the pandemic, companies were laying off employees, delaying large capital expenditures, and reducing inventories. Cost-cutting was implemented due to lower demand and a fear of the worst-case scenario. As demand has begun to pick up, requiring replenishment of goods previously deferred from production, supply chains have had trouble keeping pace. Shortages are already beginning to percolate. Restaurants, manufacturers and other employers are having difficulty filling open blue-collar positions. Large-scale commodity projects were largely delayed as market uncertainty discouraged producers from large expenditures. Now, commodity prices are rising as the world returns to normal, and supply is slow to return. As the cost of labor and material inputs rise, the price of finished goods will face upward pressure.
Computer chips, a key input for every technology from calculators to tablets to vehicles, face critical shortages. Intel believes these shortages could last several years as capacity is slowly expanded. Meanwhile, producers are feeling the heat from the chip shortage. For example, auto manufacturers have had to idle plants and delay the release of new vehicles due to the lack of available chips; simultaneously, demand for vehicles is soaring. Additionally, the United States’ most prolific trade partner is openly mentioned as an adversary by both sides of the aisle. Indeed, one of the very few things both sides of the aisle can agree on is that China is becoming a threat to America’s world order. “Taking on” China will require shifting supply chains elsewhere. These shifts come with a cost. Labor, raw material, and chip shortages will continue to increase costs throughout the supply chain, a cost that the consumer will increasingly bear.
Fuel on the Fire
Since the beginning of the pandemic, the U.S. government has responded by easing monetary policy and distributing fiscal stimulus. The current administration has proposed a $1.7 trillion infrastructure bill and a $1.8 trillion bill to address child-care, access to free education, and paid family leave. The more progressive wing of the Democratic party wants even more stimulus. That said, none of those programs to us seem likely to be enacted to nearly the degree that they were proposed. But any government stimulus creates more demand in the system when funded by debt, as it creates more money purchasing more goods. As we stated in the previous section, it will be difficult for supply chains to keep up as consumer demand returns to the system – adding sustained high levels of government spending could be fuel on the fire.
Actions to Dampen Inflation
Historically, raising interest rates is a strategy that can be used by governments to slow inflation. However, that often forces a recession, which makes either party in power reticent to slow down the economy and lower fiscal spending. While the GOP is currently negotiating the sticker price of the Biden administration’s most ambitious proposals down, we believe it will be politically untenable for either party to cut spending drastically. Voters have simply come to expect more help from the government.
Potential tax hikes could also soften the inflationary pressure from increased government spending. More money would be taken out of the hands of the private sector and placed in the hands of the government, which would be inflation-neutral or even deflationary. However, the tax hikes making the rounds in the Biden administration would be unlikely to cover sustained high levels of government spending. The large and ballooning public debt load further discourages the government from making interest rate hikes. Interest expense as a percentage of GDP would rise dramatically if rates increase much off of their current low levels. This creates a recipe for sustained inflation.
So, What to Do Now?
How should one position themselves to cushion investments against inflation?
- If owning individual stocks or sector funds, invest in companies that:
Sell goods or services that are necessities with adaptable pricing and can thus pass their increased costs onto consumers. Think utilities and healthcare.
Are companies which have strong brands that can increase prices and have consumers stick with them.
Sell products that, by the very nature of inflation, will see price increases. Think commodity sellers like companies in the materials and energy industries.
Are companies that are "disruptors"…holding promise for significant changes in the future as to how we live, work and play. Think clean energy, 5G, healthcare, gaming and many kinds of cloud and internet-based communication and transactional businesses. Many of these seem expensive now and will require "buy and hold" patience, but their future is bright.
- We continue to espouse the benefits of global investing for both stocks and bonds. Investing outside the U.S., portfolios have a natural hedge against inflation as each country will face varying inflation levels, so avoiding single-country risk means avoiding single-country inflation risk.
We believe value is set up to outperform growth during times of inflation. As interest rates rise, the values of all companies are affected negatively to some degree, but the values of growth stocks are hurt disproportionately more due to the time value of money. Value stocks are valued more considerably from near-term cash flows, while growth stocks are valued based on cash flows in the distant future. When interest rates go up, the value of those distant cash flows decreases more than the value of near-term cash flows.
With inflation generally comes higher interest rates, and with that, principal risk from long-term maturities and potential corporate defaults in high-risk companies. The time is now to keep fixed-income maturities short and bond quality high.
While we believe the trend in inflation is "actionable" as shared above, at Webster Investment Advisors we remain optimistic overall about the economy and markets and will continue to invest in a diversified approach. As always we will identify investments based on correlation and non-correlation of global asset classes to best meet the risk-reward dynamics established for each client portfolio. This has been the key to our success for the past four decades and is one of the essential ingredients to how we think about investing.
Please let us know if you have any questions about this commentary or care to discuss your asset allocation in specific.