• 02 December 2021
  • Oguz S. Ersan, CFA

Anxiety Over Inflation

One of the main concerns investors have as the world begins to emerge from the Covid-19 era is inflation. Inflation is daunting to investors because it results in a loss of their purchasing power, and it is more difficult for their investments to produce real returns above inflation. Prices have increased 6.2% since October 2020, as measured by the Consumer Price Index (CPI), marking a 30-year high. This has worried economists that we will enter a period of stagflation, which is weak economic growth combined with high inflation. Although the Federal Reserve believes inflation will settle down next year, investors should still be aware of the current and historical events surrounding inflation spikes, along with investments that have historically worked as a hedge for inflation.

A primary event that has contributed to this inflation spike is the reopening of the economy from the Covid-19 pandemic. Pandemics have historically caused a disruption between the balance of supply and demand. Typically, a pandemic would cause demand to fall due to more people being infected by a disease, which results in them consuming less. However, with the Covid-19 pandemic, policymakers distributed a substantial amount of stimulus. With the reopening of the economy, the stimulus has resulted in an increase of demand. The combination of the current supply shortage and high demand leads to higher prices, hence the sharp increase in the inflation rate. No one can be certain about how long these implications from Covid-19 will linger around the economic and political sphere. Additionally, generational attitudes are formed through shared events such as wars, recessions, and pandemics. All of the effects from a major event can often take years to appear, which means we have not yet seen all of the social changes that will occur due to Covid-19. As the newer generations begin to grow older and gain more positions of influence, we could begin to see a difference in societal and economic behavior.

Another current event affecting the high inflation rate is the supply-chain shortage accompanied with the labor shortage. The supply-chain shortage is pervasive in multiple sectors of the economy and according to Moody’s Analytics, it “will get worse before it gets better.” The computer chip shortage has resulted in a lack of new cars, which in turn, has substantially raised the price of new cars. In fact, this shortage has effected the auto industry so drastically that AlixPartners forecasts the opportunity cost of lost sales to reach $210 billion for the year. This led General Motors to shut down their production for a short time period in September. Car dealerships have very limited inventory on their lots, which makes right now a very expensive time to purchase a vehicle. Other supply shortages are occurring in the housing market and in retail stores such as grocery markets. Many shelves have appeared empty and there is likely no way to improve these conditions before the holiday season, resulting in many shoppers to rush to the stores to begin their holiday shopping early this year. Major contributing factors to the shortages include the effects of Covid-19, a dearth of workers, and port congestion. Examples can be found in a variety of industries. Covid-19 cases have recently experienced a considerable jump in countries such as Vietnam. Vietnam produces half of the apparel for brands including Nike and Adidas, resulting in supply shortages for the United States. The lack of labor is significantly prevalent in the trucking industry which has caused shipping prices to skyrocket and shipping ports to become badly congested. Many ports have shut down, in some cases due to workers becoming infected with Covid-19. When ports shut down, this causes the open terminals to become flooded. These are only some of the current events that are causing inflation to rise and instilling fear in consumers.

More threats posing a risk to the economy are rising bond yields, potential interest rate hikes, and soaring energy costs. Investors worry about a rise in bond yields because it can trigger a fall in stock prices. We recently experienced the 10-year Treasury yield rising above 1.5% and the 30-year yield rising above 2%. This resulted in growth stocks and Big Tech stocks suffering the most. When there are higher bond yields, it decreases the value of future cash flows which in turn decreases stock valuations, especially for companies with anticipated growth as a major component of their stock prices. We can also expect to see a rise in interest rates at some point between 2022 and 2023. The Fed does this to make money more expensive to borrow in hopes this will slow down the pace of price increases. Natural gas and crude oil prices have risen to a 7-year high, heating oil prices rose 68% this year, and coal prices have drastically increased. High energy prices can increase inflation and cause consumers to not spend money on other products or services. This slows down the U.S. recovery pace and weakens economic growth. The mix of high inflation and slowed economic growth is known as stagflation, a term used to describe the economic standpoint of America in the 1970’s. Although unlikely, many are wondering if we are entering a period similar to the 70’s. The Great Inflation, an event lasting from 1965 to 1982, was a period where the cost of living for Americans soared. Prices for everyday items such as food saw inflation of 15% and the unemployment rate almost reached 10%. Consumers congregated in the streets and protested against these rising prices and for an increase in their wages. Wages eventually went up, but then companies instantly increased their prices even more, almost like a never-ending game of tag. This crisis began to dissipate after then-Fed Chair Paul Volcker raised interest rates to an astronomical 20% and launched a bull market for both stocks and bonds. Although there are similarities to what is happening in the economy now, the Fed believes that this high inflation is temporary, and we do not need to worry about another Great Inflation event happening anytime soon.

In order to protect purchasing power, investors should ultimately be aware of assets that have historically performed well as a hedge against inflation. It is important to note that these assets may not offer the same protection in the future and they have other risk factors which may not make them appropriate for everyone. First and foremost, stocks can be an effective inflation hedge. Specifically, stocks in companies that are able to pass on costs to their customers and maintain, or even expand, their margins tend to be well-positioned for inflation. Additionally, stocks that are not overly-reliant on future growth may be best due to the valuation reasons explained earlier. Real estate has also been a good historical inflation hedge. Investors can invest in real estate directly or indirectly through an investment vehicle such as a publicly-traded Real Estate Investment Trust (REIT). An MIT study in 2017 proved that the income from retail property is a better hedge for inflation compared to residential, office, and industrial property. Fixed-income, cash, and cash equivalents often suffer the most with inflation. However, Treasury Inflation-Protected Securities (TIPS) are designed specifically to protect against inflation. The interest on TIPS will never change, but the par value will rise with CPI. At maturity, the investor will be paid the higher value between either the original or adjusted principal. Commodities, including gold, other precious metals, coffee, and oil have also historically worked as a hedge against inflaiton. An investor can involve themselves with commodities through ETFs, purchase them physically, buy futures, or invest in mining companies. Although inflation is often beneficial for commodities, these are extremely risky and are tied to government regulations and other events. Cryptocurrency is a more speculative investment which proponents argue can serve to protect against inflation in fiat currencies. Bitcoin, for example, has a built-in inflation hedging mechanism due to the finite number of coins that can be mined. However, there is not a long track record to prove it’s effectiveness. Ultimately, investors should diversify their holdings within their portfolio and know how much risk they are willing to take to protect themselves against rising inflation.

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.