I’m Not Betting on Sustained Inflation

(Photo:&eklesh,&nbspcc2.0)
(Photo: eklesh, cc2.0)

Inflation is a highly persistent topic for the media and for some clients as well.  Today, let me summarize my outlook and portfolio strategy.

• We have short-term inflation; Long-term inflation is the open question
• Much of the inflation we do have is due to supply-demand shocks
• Consensus opinion of macro economists & the Federal Reserve: inflation will subside
• Still, I have positioned the portfolio to mitigate inflation risk and even benefit from it if we do get it.

Inflation is a complex topic (with some even considering it boring).  Inflation matters a great deal to anyone building a retirement financial plan because all of our future expenses are at risk of growing due to inflation.  However, inflation does not impact all asset classes in the same way.  Investment strategy must factor that in.

It is important to remember that inflation is the rate of change of prices over a period of time.  It is possible to have a one time jump in prices, but that does not create sustained inflation. Supply-demand shocks that create inflation at a point in time can reverse.  A simple example is lumber prices.  During the Covid lockdown, lumber mills closed.  Supply of finished lumber dropped.  At the same time, demand for building materials was high.  Many people worked on home improvements and add-ons during the pandemic.  This create a supply-demand shock where inventory is down and need is up.  This created a large (over 100% increase) in prices.  However, lumber futures fell 40% in June.  Supply is coming back on line.  The conditions that created the demand are subsiding.  It isn’t clear that we go back to the prior prices, but even if they stay elevated and go no higher you don’t get sustained inflation.

The fiscal and monetary policy responses to Covid were huge, but they should revert over time.  We have to ask ourselves the question, “what has really changed before and after the pandemic that would cause inflation to change.”  Unless we can identify material changes, we shouldn’t overweight the short-term inflation numbers.   Yes, it is true that we have had unprecedented unemployment and fiscal spending, as well as a huge increase in the Federal Reserve’s balance sheet.  Thirty percent of personal income came from transfer payments from the government last year.  That money had to go somewhere.  It isn’t sustainable.

Below I have included blogs and interviews from leading economists Ed Yardeni, David Rosenberg and Lacey Hunt.  These materials go into a much deeper level of discussion for those who are interested.

Investment Strategy

Given the composite view of the economists I am tuned to, my base case is that inflation continues through the year but stabilizes as the government spending and unemployment benefits stop and supply-demand shocks correct.   I think the odds of sustained inflation are less then 30%.  But, what if we do get sustained inflation?   Given the potential, I have tilted the model portfolios to avoid any large damage from inflation. 

In the fixed-income space, we have reduced exposure to long-term bonds.  By keeping the exposure down, any inflation that drives rates higher will impact bonds negatively.  By biasing to short-term bonds, we mitigate the risk.

In equities, we are positioned toward high quality companies that have pricing power.   These types of companies are able to pass on increased input prices to the consumer.  They should hold up well in mildly inflationary environments.

In fact, the equity portion can benefit from inflation because a bias toward quality stocks includes those companies that have high gross-margin and can pass on inflation to the consumer.  These types of companies benefit in moderately inflationary environments.

Addition Sources:

Ed Yardeni wrote a blog entitled, “Inflation is up for Discussion” where he discusses the 4 D’s of inflation here.  He concludes, “I am counting on four deflationary forces to keep a lid on inflation.”   

Lacey Hunt, former Sr Economist with the Federal Reserve Bank of Dallas did a deep dive in a YouTube interview entitled, “Inflation Today, But Deflation Tomorrow” here

David Rosenburg, President and Chief Economist at Rosenburg Research, did an interview on YouTube, “Inflation is Temporary” found here.

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