By Jonathan Scheid, CFA, AIF®
There is no way to hide that prices are rising for the goods and services we use. A day doesn’t seem to pass without hearing of a new shortage, a supply disruption, or an increase in demand that is impacting the price we pay for something. From a shortage of semiconductors affecting the price of new and used cars to higher oil prices raising the cost of gas and backups at ports restricting supply, it is no wonder that inflation and inflation expectations are on an upswing.
The most recent report on core Personal Consumption Expenditures (PCE) price index, the Federal Reserve’s preferred measure of inflation, showed that prices were up 3.1% at the end of April versus a year ago. This increase is much greater than the average rate of 1.6% over the past 10 years, and it is well above the 2.0% rate that the Fed is targeting for long-term inflation.
Yet, the Fed isn’t overly concerned about this sudden uptick for two reasons. First, the Fed believes the number is temporarily inflated because we are comparing values from today’s healthier economy versus last year’s struggling economy. Consider, for example, that the price of oil was about $20/barrel at the end of April last year during the early part of the pandemic, and it was about $65/barrel this April, which is pretty close to where it was pre-pandemic. But that big price increase from last April to this April shows up as inflation. So, the Fed feels that we’re seeing temporary sticker shock and that the rate of inflation will fall once we are past the lows of the pandemic.
Second, the Fed feels that temporary events caused by the slowdown and restart of the global economy will dissipate once everything is up and running again. Just like paper towels and toilet paper eventually returned to stores, events like the semiconductor shortage for cars, the underproduction of lumber that led to huge price increases, and the backups at ports will all get worked out and no longer cause supply issues.
How Our Portfolios Protect Against Inflation
With the Fed’s wait-and-see approach on inflation, consumers and investors run the risk of the economy overheating and inflation getting out of control. This is concerning because it could cause the Fed to increase interest rates at a faster pace than it otherwise would have, and it potentially means that the items we purchase would more quickly increase in price.
Fortunately, we seek to manage inflation risk in the design of our portfolios. Stocks are one of the few assets that generate a meaningful return after adjusting for inflation, and that growth potential is why we include some allocation to them in almost all of our portfolio recommendations. Growing wealth in excess of inflation is critical to most people’s financial and life goals. Additionally, our preference for investing in value (i.e., inexpensively priced) stocks acts as quasi-inflation insurance, because value stocks have historically performed well during past periods of heightened inflation.
The use of short- to intermediate-term bonds in your portfolio not only helps stabilize the ups and downs that come from stock investing, but these bonds also perform better versus long-term bonds when interest rates rise. Because bond prices fall when interest rates rise, anytime the Fed considers increasing interest rates or investors push interest rates higher, the bonds in our portfolio will likely decline in value. Short- to intermediate-term bonds are less sensitive to this risk than long-term bonds.
Like it or not, inflation is always present in our world. As the economy emerges from the pandemic, we should expect inflation to be higher than we’ve seen in the recent past, and, if the Fed is correct, it should moderate at some point in the somewhat not-too-distant future. The good news is that we have considered these risks and proactively build financial plans and investment portfolios with strategies to help mitigate some of the potential challenges that inflation presents.