Inflating Inflation Concerns

April 22, 2021

Inflation is an increasing concern for many investors and consumers.  After all, a lot of money is in motion these days.  Rampant inflation can lower the value of investment returns and lead to higher prices paid for goods and services.  For the year ended March 31, the Consumer Price Index (CPI) rose 2.6%, which is above the typical Fed target of 2%, potentially backing up the concern with real data.  The Core CPI, which excludes energy and food, was up 1.6%.  CPI measures the change in prices paid for everyday items such as clothing, groceries, cars, recreational activities, and more.

Not All Inflation is Bad

While investors often fret about inflation, not all inflation is bad.  Inflation can signal that confidence is building, with the expectation of growth ahead.  Today, the re-opening of the economy on the back of rising vaccinations and immunity has released pent-up demand for goods and services.  In addition, the federal government’s stimulus measures have resulted in higher disposable income for many, thus increasing consumers’ ability to spend. This has combined to push up inflation expectations.

Producer Price Inflation

With the increased demand for products, companies are rushing to ramp up production, find enough workers, all the while dealing with a shortage of raw materials.  These shortages are increasing input costs across the board, especially for metals, lumber, food, and fuel.  The Producer Price Inflation for the year ended March was 4.23%. As producer prices increase, costs often get passed down to the consumer, which ultimately leads to inflation.

The extent of inflation in the near term, especially given the unique circumstances of the last 12 months, is uncertain.  Some inflationary pressures, such as the 13% rise in energy prices in the last year, are seen as one-off occurrences that will eventually return to more stable levels.  In any event, we’re likely to see inflation in the near term higher than the Fed’s target but probably won’t see the Fed move on this too soon.  Why?  They still have a lot of tools in the toolbox to help counter inflation if it becomes persistent.  They are also worried about deflation if the economy were to slow down again.  Inflation will also be naturally tempered by a U.S. labor market that remains 8.4 million jobs short of pre-pandemic levels.

The Value of Value

What does all this mean for your investments?  As always, it is important to be diversified in both your stock and bond holdings.  In times of inflation, value stocks tend to outperform growth stocks.  Inflation can be good for the value premium, as a large portion of a growth stock’s worth is based on the expectation of higher future earnings.  With inflation, the present value of these future earnings declines.  On the other hand, a significant portion of a value stock’s worth is based on its current or near-term earnings, which keeps value stocks relatively protected from higher inflation.

On the fixed-income side of a portfolio, diversification outside of traditional bond holdings such as government and corporate bonds is important.  Bond funds with the flexibility and liquidity to take advantage of opportunities that arise from changes in risk, credit quality, duration, and rates, will provide some inflationary protection.  Increasing our tilt towards such bonds was part of the strategy behind last month’s bond adjustments.

The path of inflation is unknown, and we are likely to see stories of inflation for months to come as inflation numbers tick up for now, and further spending is debated.  As an investor, know that your stock and bond portfolio is built for such uncertainties where you can stick to your long-term plan and continue to navigate past any type of these headlines.