Inflation: Our Thoughts and How We Respond

As investors, we all share the goal of growing our assets over time. It feels great to see your balance rise and earn a sense of security through diligent saving and investing. However, it’s important to look beyond the ledger line to understand how much our assets can provide for us in real terms. The actual goal is maintaining and improving purchasing power with our savings, and inflation can be a concern even when we see markets trending up. Prudent financial planning accounts for inflation so you’re prepared across economic conditions.

With inflation in the news for the past several months, it can be difficult to determine how much of the heightened concern is noise and how much is worth giving stock to. While it is undeniable that we are currently experiencing increased inflation—having risen 5.4% over the last 12 months as of September, according to the US Bureau of Labor Statistics—some level of inflation is par for the course. Let’s explore what inflation is in more detail, common concerns we hear from our clients around inflation, and some ideas on how to help protect your portfolio when inflation is high.

What is inflation?

In its most basic sense, inflation is “the decline of purchasing power of a given currency over time” as explained by Investopedia. While it is described as less purchasing power, how it affects us as everyday consumers is through the increasing price of goods and services. A common measure of inflation is the Bureau of Labor Statistics’ Consumer Price Index (CPI). The CPI is calculated by taking the average weighted cost of a basket of goods and dividing it by the cost over a prior period. Recent inflation has had an outsized effect in certain areas. The cost of fuel and gasoline are up 43% and 42% respectively from 12 months ago. The prices of used cars and trucks are also up 24%. However, if you look at core inflation, which is the CPI excluding the more volatile food and energy categories, the 12-month rate drops to 4%, which is much closer to historical averages. The Fed also expects increased inflation to be temporary, with projections at 2.1–2.2% in 2022 through 2024 per a report by Reuters. You can dive into the data in the US Bureau of Labor Statistics’ table of 12-month percentage change if you’re curious to learn more.

With inflation running hotter this year, what’s driving it? We typically see three different inputs that spur inflation, including: increased demand without enough supply, steady demand with falling supply, and the cycle of increasing wages and costs due to expectations about future inflation. The supply chain shutdown caused by COVID, as well as the demand rebound from the ongoing vaccination effort and reopening of the economy, are likely contributing to the increase we’re observing now.

What are the fears?

Inflationary concerns often stem from fears of the Fed responding by raising interest rates, leading to more costly borrowing and slower economic growth. However, the subsequent cooling may lower consumer demand and create deflationary pressure. It’s a delicate balance that the Federal Reserve seeks to maintain by adjusting monetary policy, but what does a potential interest rate hike to fight inflation mean for our investments? Opinion varies on short-term signals for rising rates. However, when investing for the long term, we find there hasn’t been significant correlation between interest rate changes and stock market performance over extended periods. In comparison, bond prices tend to fall as interest rates rise since existing lower-yielding bonds become less attractive relative to newer bonds with higher rates. We combat this by weighting short- and intermediate-term bonds more heavily to limit interest rate sensitivity on the fixed income side.

Another common concern we hear from our clients is fear of government overspending. However, there are two key points to remember. The first is that inflation isn’t inherently bad, and a consistent, low level of inflation often indicates steadily increasing productivity for the economy. The second is that government spending doesn’t necessarily cause inflation, and it depends on how the money is spent. There is a great analogy from The Guardian describing government spending and the economy as a flower bed:

It’s possible that overwatering could cause spillover, but it depends on how you water it and where. If you pour water in one place that is already saturated, it’s likely to flood and cause the flowers to die. In contrast, if you shower water over the whole bed, or focus on the driest areas, the water will be soaked up and the flowers will grow.

The article also highlights how massive spending following the 2008 financial crisis and recovery did not cause runaway inflation. Instead, inflation has been near record lows over the last decade.

How do we respond?

We believe the most reliable way to protect yourself from different economic conditions like inflation is to have a balanced, diversified portfolio that includes a mix of assets with real expected returns (total portfolio return less inflation). The amount allocated between stocks, bonds, and other investments like real estate will vary, but it’s during inflationary periods like this when staying on the sidelines and holding too much cash can erode purchasing power over time.

We also invest in specific asset classes to help navigate inflation. Value stocks tend to perform well in inflationary environments as investors seek present income and strong cash flows. Sectors like energy, consumer staples, and financials are prominent in value equities and often perform well during these periods. On the fixed income side, we utilize government credit in our bond allocations, which tends to be less sensitive to inflationary pressure than corporate credit. Merriman portfolios also feature alternative specialized investments in real estate, reinsurance, and alternative lending. These assets have real expected returns above inflation and are less correlated with the stock and bond markets. Real estate tends to perform better during periods of rising inflation as investors increase rents to adjust to the changing prices. Reinsurance contracts can also respond to rising costs and rates by increasing premiums annually and keeping the collateral invested in assets with at or above inflation levels of return. Alternative lenders utilize floating rates which provide flexibility in a volatile rate market as well. Specialized investments offer an alternative to purchasing additional bonds for diversification from equities and provide tools for responding to inflation.

Inflation is an important reality when investing, whether it’s how it affects portfolios or the economy as a whole. We enjoy diving into the causes, concerns, and strategies to address inflation, and hopefully provide insight to ease any worries. At Merriman, we will continue to monitor inflation and ensure we’re positioned properly to navigate changes, up or down.

All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Merriman does not provide tax or legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.