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Rising Prices: Inflation’s Impact on the Economy and Your Portfolio

By on July 1, 2021
Categories: MARKET NEWS, Uncategorized

We hope your summer is off to a great start, and that you are (finally!) returning to the activities you have missed over the last 17 months, whether that is traveling, dining out, attending movies, concerts, and sporting events, or simply spending time with friends and family.

Global equities appreciated in the second quarter even as economic news was mixed.  The yield on the 10-year U.S. Treasury bond, which is generally driven more by inflationary expectations than by Federal Reserve actions, ended the quarter around 1.5%, nearly double the yield from a year ago, but still well below the historical norm.  Employment growth continued to improve modestly coming out of the pandemic world, with businesses in certain industries facing labor shortages.  Among equity asset classes, Real Estate was once again a standout performer, with the S&P Global REIT Index rising 10% for the quarter.  Political headlines remained front and center in the U.S. news cycle with fresh economic concerns, such as rising inflation (more on that below) and an overheating economy emerging.

Asset class returns for the second quarter and year-to-date were as follows:

 

Index

Asset Class

Second Quarter 2021

Year-to-Date 2021

Barclays U.S. Govt./Credit—Int. Fixed Income 1.0% -0.9%
S&P 500 Large U.S. Stocks 8.6% 15.3%
Russell 2500 Small/Mid U.S. Stocks 5.4% 17.0%
MSCI ACWI ex-USA Foreign Stocks 5.5% 9.2%
S&P Global REIT Real Estate Securities 10.2% 17.0%

Now that the U.S. economy is reopening and people are returning to some semblance of “normal” life, you may have noticed the price of nearly everything going up.  Namely, prices of lumber, cars and trucks, gas, and housing have risen at a pace not seen in over a decade.  Inflation, measured by the Consumer Price Index (CPI), increased by about 5% in May 2021 (compared to May of 2020), the highest one-year change for U.S. consumers since 2008.  With governments and central banks around the world injecting trillions of dollars into the economy through fiscal and monetary stimulus programs, a new debate has emerged as to whether inflation is a growing threat to the global markets.  Though some prices have already begun to ease (e.g., lumber prices fell over 15% in just one week during June), the inflated prices have been acknowledged by government officials and have forced the Federal Reserve to begin strategizing about how to keep prices from rising too quickly.

Inflation is generally defined as an increase in the general level of prices of goods and services.  A corollary of rising prices is a decline over time in the “real” value of money, a loss of purchasing power where each dollar buys less than it did previously.  Economists generally agree that high inflation rates are caused by increased growth in the money supply.  While many concur that recent stimulus efforts have been essential to the post-pandemic recovery, some believe that longer-term inflation is inevitable as governments will not be able to simply “turn off” the monetary and fiscal campaigns quickly enough to keep price increases at bay.  There are two schools of thought as to what type of inflation the economy is currently experiencing:

  • Long-Term Inflation.  Over the past 95 years, inflation has averaged 2.9% per year and has quite reliably been in the 1%-to-3% range each year for the past 30 years.  It is highly unusual for prices in the U.S. to rise by double digits on an annual basis; in fact, this has not happened since 1980.  Price increases on common goods tend to be short-lived because companies eventually produce more goods to meet demand and new competitors enter the market to profit from increased demand.  But price increases on some goods and services may become “sticky” and prevail for longer periods of time.  Businesses often pass increased costs to the consumer.  Employees may then seek higher pay to keep up with rising costs, and the inflationary cycle evolves.  The persistence of high inflation generally has negative effects on the economy because it erodes the spending power of a dollar.  A dollar is not worth anything more than what it can be used to buy goods and services.  For example, assume that $10 can buy a meal at your local deli.  If we experience 10% inflation, the deli may raise the price to $11 to offset the increased costs of food and labor.  Even though you still have the same amount of dollars, your purchasing power has eroded, and now you will have to dip into your wallet for another buck.
  • Transitory Inflation.  Occasionally, a less persistent version of inflation may occur.  This inflation is real and observable but is expected to be temporary.  The reopening of the economy post-pandemic has caused spikes in demand for many goods and services.  There is a possibility that the sudden demand is too much for the economy to handle in the short-term, which is already causing severe supply chain issues to wreak havoc on companies and consumers.  Economists expect many of these price hikes to be short-lived as the economy adjusts and year-over-year comparisons to the abnormal pandemic era subside.  The last time inflation was this meaningful was in 2008 during the Great Recession — and historically, inflation has vacillated the most during and coming out of recessions.  Most of the May inflation spike this year came from industries benefitting from the reopening of the economy (such as travel and leisure) or in areas that saw abnormally high demand during the pandemic.  That is why some top economic policymakers at the Federal Reserve still think the inflation situation is under control and likely temporary.

There are very smart people with convincing arguments on both sides of the inflation debate.  Given the structure of our monetary system, inflation is always present to some extent and presents a continual challenge to those looking to grow their wealth on a “real” basis.  At Dowling & Yahnke, we follow these debates with interest, but we do not place strong bets on which way the economic winds will blow.  Our goal as your advisor is to construct a risk-appropriate portfolio that will withstand any one of numerous economic scenarios that may unfold.  We believe that the best way to accomplish this task is through robust diversification, since different asset classes thrive in different economic and inflationary environments.

In an inflationary world, stocks generally outperform bonds since companies can raise prices to keep pace with rising labor and material costs.  On the fixed income side, Treasury Inflation-Protected Securities (TIPS) are designed to protect against rising prices.  The principal value of these government bonds increases with the Consumer Price Index (CPI), thereby providing a rate-of-return above the measured inflation rate.  Exposure to real estate, through either real property or real estate investment securities (REITs), also typically provides a good inflation hedge, since landlords can raise rents over time.

What types of assets generally perform poorly in an inflationary world?  Long-term bonds, cash, and savings vehicles with very low interest rates.  Earning next-to-nothing on your cash while overall prices are rising means you are losing purchasing power with your current dollars.  While bonds generally do not produce exciting returns in inflationary environments, they still serve an important role in portfolios.  If you receive 2% interest on a bond and inflation is the same or higher, you are just about breaking even from a real yield perspective.  Keeping up with inflation is better than holding cash.  But why even invest in low-yielding bonds when inflation may be increasing?  There are two primary reasons:

  • Liquidity in times of stock market volatility.  The stock market can remain in downward cycles for long periods of time — and, as we experienced in February and March of 2020, can drop quickly without warning.  Bonds provide “dry powder” for opportunistic rebalancing opportunities and generally dampen portfolio volatility.
  • Portfolio safety.  We have never invested in bonds with the goal of generating high returns.  The high‐quality, relatively short-term bonds in our clientsʹ portfolios provide capital preservation and safety along with income.  Bonds give us stability and liquidity to fund short-term needs, regardless of what is happening in the equity markets in the short term.

Although the idea of prices rising all around us can be concerning, we position portfolios with the information currently available to thrive in a variety of economic outcomes.  We always view inflation (whether high or low) as a risk and position our portfolios to generate real returns over time to help our clients meet their objectives.  Our goal is to help you structure your overall financial situation in a manner that enables you to withstand inflation and other challenges that will inevitably come our way.

Lastly, we are excited to announce that as of June 30, 2021, we finalized our strategic relationship with CI Financial Corp.  We appreciate your support during this transition period.  We have entered this relationship with one priority – to provide our clients with a higher level of service in an increasingly complex financial world.  In the coming months, we look forward to leveraging CI Financial’s depth of expertise, resources, and technology.  Of course, your dedicated D&Y team is available if you have any questions.

Please note that we have amended our SEC regulatory disclosures and Firm Brochure (Form ADV Part 2A) reflecting the ownership and acquisition by CI Financial whereby Dowling & Yahnke, LLC became a wholly owned subsidiary of CI US Holdings, Inc. owned by CI Financial Corp.  A copy of our brochure is available on our website and can also be delivered electronically (e-mail) or in hard copy upon request.

As always, we thank you for your continued support and invite you to contact us with any questions regarding your finances.

Have a wonderful and safe summer!

Sincerely,

Dowling & Yahnke Wealth Advisors

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