Don’t Let Inflation Scare You Out of Stocks
As Miles discussed in this month’s Investment Comments, inflation has reared its ugly head for the first time in many years. For those of us that remember the 1970s “stagflation,” a combination of persistently high inflation paired with slow economic growth, just the word “inflation” brings to mind poor stock returns. Let’s delve a bit deeper into the damage inflation causes, why it has spiked, the prospects for the spike to continue, and our thoughts on what you should do with your portfolio, particularly your stock allocation.
Why is Inflation a Problem?
Rising inflation causes problems for everyone. For consumers, the ability to purchase goods and services is reduced as the currency they hold is no longer worth what it was in the past. Businesses endure two negatives: revenue can be suppressed as consumers can’t buy as much as they could before, and input costs are now higher, hurting profits. The overall economy slows until everyone has adjusted to the new price levels. If inflation is persistent these impacts are reinforced as workers demand higher wages to offset the reduction in purchasing power and business profits take a further hit from the higher wage cost. In the 1970s persistent inflation, exacerbated by higher energy input costs from two oil shocks, created stagflation as the economy never got a chance to fully adjust.
How Did We Get This Inflation Spike? Will it Persist?
Last summer the reduction in activity during lockdowns to fight COVID-19 caused prices, mainly for services like travel or dining out, to fall sharply. The Consumer Price Index reflected this drop, as the 0.3% advance for the second quarter 2020 was down from the average annual 2% increase for 2016-2019. Fast forward a year and the June CPI increase year-over-year is 5.4%, the fastest pace since August 2008 and a number that has, rightfully, gotten a lot of attention.
So why has inflation spiked? There are several factors, the first of which is the simple recovery in services pricing as vaccinated consumers, with government restrictions largely removed, are free to travel and eat out again. For example, while airfares in June were 24.6% higher than a year ago, a huge jump, last summer they fell an even larger 27.1% when compared to 2019. Drops of this magnitude for services last summer reduced the overall CPI while the corresponding increase this year, just from normalized pricing, has caused an elevated advance. This boost to inflation should only be temporary.
The second factor impacting inflation is the limited supply of goods from global supply chain disruption as overseas economies lag behind the U.S. in reducing COVID-19 restrictions. Further, demand for computer chips has taken an outsized step up since the onset of the pandemic, leading to shortages as foundries were already operating at full capacity. With long lead times to build more plants, chip makers have prioritized selling more profitable chips for laptops and cell phones while reducing lower profit chips, particularly for autos. Without computer chips automakers can’t build new cars, leading consumers needing transportation to purchase used vehicles. In a similar pattern to airfares, used car prices dropped last summer but over the past year have increased a staggering 45.2%. This jump alone accounts for about 1/3rd of the total rise in June’s CPI. Like services pricing, supply chain disruption should recede over time and the associated inflation along with it.
The third factor supporting higher prices is the tremendous amount of fiscal and monetary support provided the economy in the past year. Roughly $5.6 trillion has been provided in fiscal relief since March 2020, representing about 25% of annual gross domestic product. This staggering amount of spending included stimulus checks that have left consumers flush with cash they struggled to spend but now can with a fully reopened economy. Monetary support has also been substantial as the Federal Reserve cut its Federal Funds rate to zero and has purchased nearly $2 trillion of treasury bonds and mortgage-backed securities, substantially expanding the money supply. The reduction in interest rates sparked a mortgage refinancing boom that has further added to consumers’ cash balances from interest rate savings. It seems this recent boost in demand, particularly from the $1.9 trillion package passed in March, should dissipate over the next few months if no further fiscal stimulus to fight the pandemic is needed.
The impact of these three factors on inflation appears to be temporary. However, the fourth factor impacting inflation, shelter costs, does not. Shelter costs make up about 1/3 of CPI and are largely based on rental costs that increased only 1.9% in the past year as renters moved out during the pandemic to buy homes. However, in May the median existing home sold for $350,300, a 23.6% increase year-over-year. Work done by Kathy Bostjancic of Oxford Economics indicates this large increase in shelter costs will take about 18 months to fully reflect in the CPI. Unless housing prices cool significantly in the next few months, it seems likely that the increase in shelter costs will push the CPI past the Fed’s desired 2% target for longer than it desires.
The Impact of Inflation on Stocks (and Bonds)
Studies examining the impact of inflation on stocks have produced inconclusive results due to variables including geography, time period, market conditions, and government monetary policy. However, studies that have looked at inflation-adjusted returns (actual return less inflation) have concluded the strongest real returns have occurred when inflation is 2% to 3%. This makes sense as confidence in price stability allows everyone in the economy to make future plans that ignore inflation risk.
The rate of inflation does impact different types of stocks. Stocks in the Value category have strong current cash flow that is expected to moderate over time. Stocks in the Growth category have little or no cash flow now but are expected to grow substantially in the future. Rising inflation is generally accompanied by increasing interest rates to combat the higher inflation level. Growth stocks are more sensitive to increases in interest rates due to their dependence on future economic growth that is now slowed by higher interest rates. Value stocks tend to increase in value or hold up better from the near-term certainty of their cash flow. In a similar fashion to Value stocks, stocks that pay a dividend tend to hold up better than pure Growth stocks.
We can get a sense of this dynamic by looking at the high-inflation 1970s as financial writer and author Brett Arends has done. After adjusting for inflation, the S&P 500 endured a loss of 16% during the decade, not surprising given the number of large growth stocks in the index. Energy stocks did the best, returning 73%, reflecting the surge in oil prices. Real Estate Investment Trusts (REITs) returned 36% as real estate prices advanced in step with higher inflation. Somewhat surprisingly, Utilities stocks lost 9%, but this can be explained by their dividend yield not keeping up with inflation and their profits hurt by higher energy input costs.
Even though stocks did poorly, the asset class that suffered the worst loss during the 1970s was 10-year treasuries, down 38%. A loss on treasury bonds is unthinkable to most of today’s investors who have experienced only positive returns since the early 1980s as interest rates progressed on their multi-decade decline. But with interest rates during the 1970s on a continual descent the value of previously issued bonds headed lower, leading to large losses.
What Should Investors Do Today?
Reopening the U.S., and hopefully soon the global, economy from the pandemic has created a challenging and uncertain investment environment. Inflation has risen faster than anyone anticipated, including the Fed, but at least part of the increase looks temporary. Interest rates have gone down since the start of the year as investors believe the recent inflation spike is temporary and, if it isn’t, the Fed will adjust monetary policy accordingly to bring it back down to its 2% target. If this comes to pass interest rates will stay low and the return on bonds will remain unattractive relative to stocks.
But what if the Fed and investors are wrong and inflation runs faster and longer than the consensus view? That would imply interest rates will increase to fight this higher level of inflation. Rising rates won’t be great for stocks but they will certainly be far worse for bond returns. Further, we are confident that our stock selections stand a better chance of producing return given our focus on both Growth and Value characteristics. Our conclusion: stay in stocks.
Dan Boyle, CFA