Published On: May 14, 2021
Written by: Ben Atwater and Matt Malick
Markets are spooked about the threat of accelerating inflation. Equity market volatility spiked this week following reports that both the consumer price index (CPI) and the producer price index (PPI) exceeded economists’ expectations and showed robust price increases year-over-year.
Sustained high inflation typically leads to higher interest rates as bond investors demand a better return to keep pace with price increases and expectations grow that the Federal Reserve will raise interest rates to cool off an economy that is running too hot.
For now, the Federal Reserve maintains that these price increases are “transitory” and will subside in due time without materially impacting monetary policy. After all, recent inflation readings reflect a comparison to 2020 when businesses were closed and consumers were stuck at home. Naturally, comparisons between a reviving economy and one that was essentially shuttered due to COVID-19 are going to show price jumps, at least until the supply of goods adjusts to meet growing demand.
While predicting the future is a futile exercise, our best guess is that the supply of most everything from food, fuel and homes to microchips, cars and RVs will adjust and inflation will ultimately moderate. And the market seems to support this expectation. The 10-year TIPS/Treasury “breakeven” rate, which reflects market expectations for inflation, shows a 2.5% inflation rate, far below the April reading of 4.2% and not far from the Federal Reserve’s target of roughly 2% inflation.
Furthermore, inflation went through a similar cycle back in 2009 and 2010, rebounding forcefully from a financial crisis low and suggesting 10-year inflation in the mid-2% range, which never materialized on a sustained basis.
But the risk of inflation is certainly feasible, especially given loose monetary policy and massive fiscal stimulus programs that are likely to be only partially paid for with tax increases. If inflation does pick up pace and last longer than we expect, our clients’ portfolios should be fairly well positioned.
First, we have long maintained a disciplined process of laddering individual bonds to provide regular cash flows and systematic rebalancing. If inflation rises and interest rates follow suit, we should have plenty of opportunities to buy new bonds at higher yields.
Second, our equity portfolio should fare better than most during an inflationary cycle. For starters, inflation may actually help our industrial names, particularly those that would directly benefit if Congress passes a large federal infrastructure bill (think Caterpillar, Waste Management and Cummins). And our stock portfolio is value-oriented, consisting predominantly of dividend payers that generate strong free cash flow. Higher interest rates should favor value stocks over growth stocks, the theory being that a stock’s value represents the discounted present value of future cash flows, meaning that dividends paid today are worth much more than growth in the future when rates are high.
As always, our goal with our investment strategy is to maintain a long-term discipline that is effective and repeatable through various market conditions. If you have questions about your particular portfolio as it relates to your financial goals, please do not hesitate to reach out.