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What You Need to Know about Inflation and Your Portfolio

2/9/2022

While Covid and politics still dominate the news, more headlines are focused on inflation.

Economic growth appears solid, but that is exactly when the Federal Reserve needs to act. In the words of former Chairman William McChesney Martin, the Fed’s job is “to take away the punch bowl just as the party gets going." The challenge is that the Fed failed to notice the party was in full swing for six months. Perhaps the reason it has fallen way behind is that it not only served as bartender but began imbibing its own concoction.

Inflation soared to 7% in 2021, a rate last reached 40 years ago. Even excluding the volatile food and energy sectors, so-called “core inflation” rose 5.5%, the highest in 31 years. Left unchecked, inflation can become imbedded in our cost structure through cost-of-living allowances in wages and Social Security. On top of that, flaws in the way housing is figured into the Consumer Price Index mean that recent increases in home prices and rents have yet to be fully reflected in inflation statistics.

One minor cause of higher inflation is that prices were subdued by weak demand in the early part of the pandemic, leading to below-average inflation of 1.2% in 2020. However, the real culprits are overstimulated consumer demand at a time when global production and transportation have been affected by responses to Covid.

The Fed dropped interest rates to zero in March, 2020 and took other actions such as purchasing Treasury and mortgage bonds. At the same time, Washington unleashed three waves of stimulus spending. While these responses made sense at the outset of the pandemic, the economy stabilized fairly quickly and each additional round of stimulus has become less effective and less necessary.

Despite generally strong job gains and an unemployment rate approaching the record low of 3.5%, the U.S. still has 2.7 million fewer people employed than in January, 2020, even as GDP roared past pre-pandemic levels. A lack of workers has constrained our ability to meet demand for goods. When demand is greater than the capacity to produce, manufacturers, distributors, and retailers have the opportunity to raise prices. That is how supply and demand interact. Higher prices should draw out more supply, but few firms will build more factories to meet a temporary supply-demand imbalance. Higher wages are drawing out more workers, but whether through fear of contracting the virus, child care requirements, or a decision to retire, the workforce hasn’t re-bounded fast enough. Typically, consumers would say no to higher prices, but U.S. consumers are flush with cash following three rounds of stimulus and reduced opportunities to spend in early 2020. They have largely cooperated with rising prices. Imports haven’t provided much relief, as China’s “Covid Zero” policy has led to reduced factory output.

All signs point to strong U.S. growth, and that is part of the problem. GDP is expected to rise at an annualized rate of 7% in the fourth quarter, up from a disappointing 2% in Q3. About 90% of the global increase in consumption of durable goods (autos, appliances, furniture, etc.) since 2018 has occurred in the U.S. Strong demand from the American consumer is stoking global inflation. U.S. factories are trying to keep up, with U.S. spending on factory equipment rising 13% last year vs. 3.6% growth in the eurozone and flat spending in Japan. Still, it hasn’t been enough to keep pace with demand.

Equity investors need to be cautious given the Fed’s growing realization it has fallen behind and its determination to make up for lost time. But where else can we turn? Bond yields will likely go up, causing prices of existing bonds to decline. Yields are already lower than inflation. Build up cash? Bank, CD, and money market yields are virtually zero, or -7% in real terms. Commodities? Not a good answer since they will likely bear the brunt of any economic slowdown.

Even when it is uncomfortable, our approach is to remain fully invested most of the time. When the market turns choppy. we look for opportunities to make shrewd investments, setting ourselves up for success when the market stabilizes and goes on to new highs. In our February 2022 issue, for instance, we made three recommendations for subscribers -- a software infrastructure company, a medical devices maker, and a gaming software business.In the view of our analysts, these companies are positioned to perform better than the broader market over the next several years.

The lack of appealing alternatives to equities in general suggests staying the course. But the captain has turned on the seatbelt sign as we have some turbulence ahead so please remain in your seats.


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