You can’t read much in the financial press these days without being confronted by the challenges of inflation. It’s hit the economy with a vengeance. We all know that inflation erodes our purchasing power and thus there is a big temptation to do something to inflation-proof our portfolios.The hard part is no one has a good sense of what this inflationary cycle is all about. Will it be short-term, long-term, mild, or run-away inflation? Each of these paths can have a materially different impact on markets and the economy. Until you can define the problem, it’s hard to settle on a solution. Given this uncertainty, you may want to sit tight on any bold moves to address the challenges of inflation.
It’s no secret that the last time inflation was a serious problem was the 1970s. But it took time for inflation to grab hold of the economy. In 1968, the annual inflation rate topped 4%, but it took until 1975 for it to exceed 10%. Before 1968, inflation spent many years averaging below 2%. Today, we have a sudden shock of inflation. It went from averaging less than 2% for the past decade to about 7.5% today. The question for investors is whether this is a paradigm shift that requires fundamental changes to your strategy or a cyclical shift that will run its course in a year or so.
If core inflation subsides to 2.5% or less, as the Fed thinks it will within the next year or so, then we’ll likely go back to the regime that dominated markets for the past decade. Low inflation, low interest rates, low GDP, and a premium paid for companies that can grow in that environment. But if inflation stays elevated, say above 5%, and interest rates rise, then investors may be attracted to higher income producing investments, such as higher dividend paying stocks, higher income-producing debt, and commodity exposure. They may also shy away from growth investments with little current income.
Another possible scenario is we get into a shrinking or stagnating economy but still have high inflation. This is the more difficult scenario and could change all sorts of risk profiles in the stock and bond markets.
My point is there are many different paths this could take, and markets don’t yet reflect much of a fear of inflation. For instance, if investors believed inflation would be high for a long time, we should see materially higher interest rates on bonds. But 10-year U.S. Treasury bonds still yield less than 2%. That rate certainly doesn’t seem to adequately compensate investors for the risk of more entrenched inflation. In the 1970s, the yield on the 10-year Treasury bond averaged more than 7%.
The dividend yield on the overall stock market doesn’t adequately compensate investors for the risk of inflation either. In the 1970s, dividend income production from stocks averaged over 4%. Today on the S&P 500 index, it’s about 1.4%.
The bottom line is that not much is priced today as if we are going to have an inflation problem. And if inflation proves to be more entrenched, at some point in the future, investors will have an “aha” moment, and then much will change. Conversely, if inflation fades away like bell-bottom jeans and the hula hoop, then probably not much will change.
Often, people who make the boldest predictions about the future of financial markets get the most press. Being strong gets attention. But there will be many “strong and wrong” predictions about markets and inflation.
It’s hard to get much coverage if you say, “I don’t know.” But if you are serious about managing risk, you try to make the most honest assessment you can. And today, I think it’s fair to say, “I don’t know,” and thus shy away from bold moves that could be costly if you are wrong.
Here is a simple example that might help. Let’s say you go walking in the woods and get lost. You don’t know if you should go left, right, backward, or forward. What should you do? Well, the best advice is to stay put. Don’t make things worse by making an uninformed decision. In investing, sometimes it’s alright to just stand still and wait until you know more before picking a path.
Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.
By CHARLIE FARRELL |The Denver Post