Adding Value Q2 2021: The impact of inflation on your portfolio
Inflation is said to be an investor’s kryptonite. The factors that lead to inflation are complex and based on the interaction of monetary policy and the real economy. Now, it may seem a little odd to be talking about inflation in the midst of a recession, but the uptick in inflation headlines and the dramatic policy response to COVID-19 has left many investors with questions about the near- and long-term implications. Unwinding the underlying issues and answering these questions is the focus of this quarter’s Adding Value.
Historical U.S. perspective
In the U.S., inflation has not been an investment problem since the 1970s, when it was a huge problem. In 1973, there was a war in the Middle East and a subsequent oil embargo, which cut off the oil supply for the U.S. and other industrialized economies. You suddenly had 20% less oil, with unabated commercial and consumer demand. So, the price had to go up to clear the demand, which sparked a debilitating cycle of inflation.
When interim peace agreements were made, and circumstances normalized, the flow of oil resumed. Even though the price of oil did not fall to the artificially low levels of the late 1960s and early 1970s, it did stabilize. Then, in 1979, the Shah of Iran was overthrown, U.S. hostages were taken, and Iran was attacked by Iraq, starting the Iran-Iraq war. The region was in crisis, U.S. – Iran relations were beyond tense, and another embargo ensued. This led to a second oil price shock created by supply disruption. Inflation went out of control.
- Periods of rapid inflation occur when the prices of goods and services in an economy suddenly rise, eroding the purchasing power of savings.
- The 1970s saw some of the highest rates of inflation in the United States in recent history, and interest rates that rose to nearly 20%.
- Monetary and fiscal policy, the abandonment of the gold standard in 1971, and market psychology all contributed to a decade of high inflation.
- High inflation + a bear market = a retired investor’s worst nightmare.
- Those of us who lived through those inflationary years never want to see them return. We were actually buying our first home in Pittsburgh when mortgage rates were 18.5%.
CPI: the flawed, official measure of U.S. inflation
The U.S. Bureau of Labor Statistics (BLS) uses the Consumer Price Index (CPI) to measure inflation. The CPI looks at the prices of 80,000 consumer items, tracking changes over time. The CPI also uses a chain-link method of calculation that allows for substitution. Let’s say we were tracking beef and chicken. Beef is up 47%, while chicken is up 6%. Well, the BLS assumes that consumers will be priced out of beef and will instead choose to eat chicken. Further, they could lower the 6% price increase of chicken by adding pork to the category mix, which is the same price period over period. This is one way you could arrive at an official inflation rate that seems pretty disconnected to what people are actually experiencing. It’s important to note that the BLS does not make any assertions that you will actually substitute products. They just say that you could if you wanted to. So, you will only be victimized by inflation if you continue to eat beef. This “logic” is baked into their CPI calculations.
There are infinite variations of this chain-link methodology. Let’s say wheat prices went up, and oat prices held steady. The BLS will say you don’t have to buy wheat bread, you could buy oat bread instead. If you need to buy a shirt and cotton prices are up, you could choose to buy a shirt made of wool. You like coffee? The price of coffee is up a lot, but you don’t want to pay it? You could become a tea drinker. This is how the government can utilize select data to direct the inflation narrative. Additionally, the BLS has separate, distinct CPI measurements, which include:
- Core CPI, defined as CPI excluding food and energy prices
- Food CPI
- Energy CPI
- CPI-W, for Urban Wage Earners and Clerical Workers
- CPI-E, for Americans 62 Years of Age and Older
- Headline PCE deflator, which uses an evolving chain-weighted basket of consumer expenditures instead of the fixed-weight basket used in CPI calculation
Individual government agencies can decide which form of CPI to use to guide their policy decisions. For instance, the Social Security Administration uses the CPI for Urban Wage Earners and Clerical Workers to calculate cost-of-living adjustments (COLA) for social security benefits. Some argue that this index does not accurately reflect the inflation experienced by the population impacted, and should be changed to the Experimental CPI for Americans 62 Years of Age and Older. To date, this change has not been made.
While annual CPI inflation has increased noticeably this year, rising from 1.4% in January to 5.0% in May, from a long-term perspective, inflation measured by the major CPI indexes (excluding energy) has been fairly consistent since the start of the 1970s, as illustrated in the chart below.
Another hedonic adjustment that the U.S. Government uses to calculate CPI is product improvements. At one time, the CPI included a 27-inch cathode-ray tube television retailing for $250. Then the plasma-screen television came along. The BLS then replaced the $250 TV in the CPI basket of goods with the $1,345 plasma TV. This substitution did not increase the CPI reading for inflation. The reasoning is that a product improvement is not inflationary because it’s not the same product, it’s a new product. CPI adjusts only for apples-to-apples price changes. However, if in the following reporting period the price of a plasma TV dropped from $1,345 to $1,200, the index would then reflect the 7% price drop, because it’s the same product.
Armed with this information, you can understand why it is not an extreme view to say that CPI will not tell you what the experienced inflation rate is. In fact, CPI may not reflect changes to your household expenses much at all. But with the wrong information, you won’t receive fair warning when inflation does become threatening. The reality is that the hedonics used by the government to measure inflation are unscientific and inexact, to say the least.
The pervasiveness of inflation
Prices for many consumer goods are more than double that of 20 years ago. When you hear old-timers recall that “a movie ticket only cost a buck-fifty when I was your age”, they are making, perhaps, a more salient observation about inflation than that provided by the CPI. The rising cost of goods and services over time illustrates the decrease in the purchasing power of the dollar. Just observe how quaint the numbers for the 1971 Cost of Living look today!
If you had $100 in 2000, and left it in savings, it would only wield two-thirds of the purchasing power it did in 2018. If you don’t invest your money, or invest it at a rate less than the rate of inflation, it can lose value over time.
In fact, if your bank account (or CD) does not pay more than the average rise in inflation for that year, you will still lose value. For instance, let’s suppose the average rate of inflation was 2.2% and a CD paid an annual interest amount of 1.5%. Your $100 CD would have earned $1.50 (totaling $101.50) a year later, but the value would have decreased by 0.7% (1.5%-2.2%= -0.7). The purchasing power of the CD would be $100.78, and you would have lost $0.72 cents to inflation. In a low-interest rate, inflationary environment, leaving cash in a savings account is essentially losing money safely. At the end of the day, it’s the purchasing power that counts. That’s what you spend. Nominal relative returns are irrelevant. To some extent, you may not be experiencing the official U.S. Government rate of inflation, but that doesn’t matter much if your purchasing power is worse than it was and getting weaker!
The black box of COVID
The arguments are raging as to whether we are in an inflationary or deflationary environment, and if it is transitory or permanent. At the 2021 Virtual Strategic Investment Conference (SIC) I recently attended, there were at least five hours of discussion devoted to the topic, but no consensus was reached.
For the inflation side of the argument, we should distinguish between service inflation and goods inflation. Services are the intangible things that you can’t put in your pocket, such as rent, healthcare, college tuition, insurance and entertainment. Service inflation has averaged 2.8% for the last 20 years, and about the same over the longer term. It is rarely flat and never negative. Goods are material objects such as food, fuel, clothes and computers. Goods inflation has had no change at all over the past 20 years. There are two key factors that have kept goods inflation at 0%: China and globalization. China has essentially become the global manufacturing center for all manner of products, and has dominated the sell side internationally by keeping prices low.
Think back to early 2020 when China basically shut down. Suddenly, there was a paradigm shift revealing America’s vulnerability to ocean-spanning supply chains. Instead of focusing on products with the lowest cost, Americans were demanding products at any cost. There are programs in place to begin reshoring and reopening manufacturing facilities in the U.S., but it’s much more expensive in the short-term than continuing to import goods from China.
The pandemic and its associated restrictions hit the service sector like a tsunami. Unemployment skyrocketed, and the government responded with a stimulus program which sent checks directly to consumers to help keep millions of suddenly jobless service workers afloat. Most Americans got a check, whether they needed it or not. And unlike typical recessions, where you see wages cut or raises postponed, salaried employees saw little effect on their pay. With recovery now fully underway, employers need workers again, and are often paying higher wages to get them. If there is service inflation on top of goods inflation, it’s hard to see how we will avoid entering into a new inflationary cycle.
Finally, consumer psychology is changing to a “buy in advance” mentality, where consumers fear higher prices and interest rates tomorrow, and buy today, reinforcing upward pricing pressures. Jim Bianco, President of Bianco Research, summed up his view on inflation this way at the SIC conference:
“Everybody is stuffed full of money. They're buying stuff like crazy. The supply chain cannot keep up…There is a simple fix for the supply chain. Charge more money. That's called inflation.”
There’s a big difference between inflation that’s transitory in absolute terms and inflation that’s transitory only in rate of change. Inflation is transitory in absolute terms when prices go up due to a temporary supply shock, then come back down. This is what Chairman Powell is hoping for. Inflation that’s transitory only in rate of change would mean that a broad set of prices jumped quickly, but never actually came back down to prior levels. That’s the wild card in the deck and something the U.S. has not seen for quite some time.
On the other side of the fence are the deflationists. From the deflationist point of view, three conditions exist that will prevent inflation from taking hold:
- Excess debt suppresses economic growth by diverting spending to debt servicing and away from lending;
- As a population we are aging, and older people simply don’t buy as much new stuff; and
- Innovative technology will fight back wage growth while keeping productivity high. This is known as Wright’s law (no relation), which says for every cumulative doubling in the number of units produced, costs associated with technologically-enabled innovation decline at a consistent percentage rate.
Japan is the poster child for deflation. They’ve unsuccessfully tried to break their deflationary cycle for the past 20 years. High debt, an aging population and new technology has kept Japan on a deflationary path.
Deflation? Inflation? Transitory? Permanent?
It will take time to determine whether current price increases are in fact transitory. Rising inflation means rising interest rates. Rising interest rates are like leeches to the Federal budget, as they make loans more expensive and drive up the deficit. Interest rate levels affect the value of the USD. A declining dollar is inflationary. The costs of the Fed not getting interest rates exactly right are high. Policy makers are walking a fine line and probably sleeping fitfully.
As we stated earlier, those of us who lived through the inflation of the 1970s would prefer to avoid a re-occurrence. Retirees on fixed incomes are sitting ducks without an appropriate COLA adjustment. As investors, we want to own businesses with pricing power that can improve their margins if inflation arises. We want to own manufacturers that are producing needed commodities. We want to own assets with short duration, especially when interest rates start to rise. Some prognosticators will suggest buying gold, which seems to us more of a “feel good” investment during a period of monetary disorder, than an asset to target. For the record, we will not take overt positions in gold.
So, like most topics we cover, we expect that the alarming headlines will continue, and that we will continue to see significant inflationary pressure in the near term. But there is some good news! We are not making a bet one way or the other about inflation. Instead, we manage client portfolios for a variety of macroeconomic environments at the same time by owning globally diversified assets. Areas of your portfolio work differently under different macroeconomic times. Since September 1, 2020, value stocks, which tend to outperform during inflationary times, became the leaders, recording their strongest short-term performance against growth stocks in over a decade. So, portfolios already have the antidote to inflation - financials, industrials and healthcare (growth stocks had done well the previous 10 years, following the financial crisis of 2008-09). We, too, walk a fine line with allocations to growth vs. value, domestic vs. international, U.S. bonds vs. international bonds, but feel that this rotation to value stocks is a healthy development. While the trend to value is now “our friend”, we continue to track economic developments and rebalance our allocations, with the intent of staying ahead of the inflation monster if it becomes more intransigent than expected.
It is hard to distill the complex economic environment into a few key points without a lengthy memo, but here is where we stand:
- Inflation is back;
- It is unclear whether it is transitory or permanent;
- If the inflation increase is permanent, there will be an adjustment as interest rates rise and stock prices recalibrate;
- We are keeping some portion of your portfolios in stock sectors that are better positioned to deal with higher inflation;
- These stocks have already benefitted as the value-style has overtaken the growth-style since the 4th quarter of 2020;
- There is no clear answer yet in which direction the economy will shift.
Stay tuned for additional updates on the actions we are taking in portfolio management to minimize the effect of inflation as we exit the pandemic and the new economic environment comes into focus.
Kathleen S. Wright, CFA
President and Managing Partner
Kathe founded Wright Associates on the principle that to build trust you have to provide exceptional value. That means developing and implementing customized plans that deliver targeted results and evolve as needs change.