Inflation Surprise


Inflation got real…seemingly overnight. In December, the headline was “Inflation hits 40-year high at 7.0%.” That was a bit shocking, until January came in at 7.5% and February at 7.9%. Sadly, inflation shows absolutely no signs of slowing down. Price increases are broad-based, and commodities (raw material prices) have only recently begun to spike higher. It is tempting to spend a couple of paragraphs here pointing fingers and assigning blame, but instead, I will share some thoughts about how higher inflation affects families, retirees and financial markets…and what to do about it.

Inflation not as bad if you are wealthy

America’s wealth gap has been widening for some time, and the current inflation spike is accelerating that trend. Although prices have increased on virtually everything, so have wages for working families and Social Security income for retirees. However, lower earning households have lost ground even after factoring in rising incomes. For example, the lowest income earners (under $20k per year) have seen their earnings grow by roughly $500 over the past year, but their annual expenses have grown by almost $2,000. The increases for gas, groceries, and rent are devasting for folks earning $12-$15 an hour. This is not the case for households earning $100k+. High income households have realized income increases greater than the inflation of their household expenditures over the past year.

Higher net worth households are also more likely to own real estate and stocks, both of which tend to grow faster than inflation over any significant period. Inflation of 4, 5, or 6% is scary, unless your income and assets are growing at that rate or higher.

Which investments do poorly in times of inflation?

Anything with a fixed interest rate becomes a dog with fleas as inflation increases. This includes CDs, savings accounts, bonds, and fixed or immediate annuities. Suppose you put $1,000 in the bank a year ago because you wanted to keep it safe. It may be safe, but today, that $1,000 only buys the goods and services that $930 would have bought a year ago. How much will it buy in 5, 10, or 20 more years?

Everyone needs some safe money in the bank for day-to-day spending and an emergency fund, but suddenly, there is a real cost to having too much money sitting on the sidelines. We commonly think of investment risk as a decline in principal, but another type of risk is holding investments that increase, but more slowly than the rate of inflation. This risk was a non-issue for the past couple of decades, but investors are starting to notice that the math is not pretty when you earn 0.5% on your savings account and prices are rising by 7%.

The other issue with Inflation…rising interest rates

You might think that money would be flowing out of stocks given the inflation problems (higher raw material costs for companies), high degree of uncertainty in the world, and stock valuations that are not cheap. The problem is where is the money going to go? Typically, when money flows out of stocks, it goes into bonds; however, bonds are the asset class seeing the largest outflows.

You might have heard that as interest rates rise, bond values fall. That’s a mathematical fact, which has seemed purely academic over the past few decades since we have not seen a significant rise in interest rates for several decades. In fact, since 1990, investment grade corporate bonds have only had 5 down years and the worst was only -5.07%.

YTD, as of 03/31/2022, the Vanguard Total Bond Market Index Fund (BND) is -6%, despite paying 2.05% interest. And if you thought that was bad…the 20-year Govt bond ETF (TLT) is (-11%) YTD. Longer maturity bonds get hurt considerably worse than shorter maturities when rates rise. The bottom line is bonds, traditionally thought of as “safe,” performed worse than stocks in Q1 2022 and just closed out their worst quarter since 1980.

Is this time different?

There is a saying that the four most dangerous words an investor can utter are “This time is different.” So, I am really trying hard not to say that. However, this time really does seem different. The last time inflation was this high (1982), the fed funds rate was 13% (currently .25%), unemployment was 8.6% (currently 3.8%), and the economy was in its third recession in ten years with no help from the government. Currently, the economy is very strong (5.7% GDP growth in 2021), and the government has just concluded the largest stimulus program in history over the past 2 years.

So, hopefully, this ends differently than previous inflation spikes of this magnitude, which have almost always led to a recession.

What is the government (i.e. the Fed) doing about inflation?

The Fed only has two mandates:

1) Keep the economy at full employment (unemployment rate under 4.5%), and

2) Keep inflation around 2%.

They are getting an “A” on the employment front and an “F” on inflation. The only tool in the Fed’s toolbox to combat inflation is increasing interest rates. This is intended to slow the economy, so we don’t have too many dollars chasing too few available goods. The trick is to do this without causing a recession. Good luck, Jerome.

Bottom Line:

Don’t keep too much in cash or savings; bond holdings should be short maturities right now, the stock market could be bumpy, but it is still the best place to be long-term. Don’t try to time the market (ever). Retirees should always own their homes because rental increases are too unpredictable (+11% nationwide in 2021), and book your summer travel ASAP before prices go up.

Questions?  Comments?  Email Me.

Have a great week.

For more, read: Four reasons high inflation won’t go away in 2022