Perspective on Inflation, Recession, Stagflation, Deflation

To date, we’ve all seen price increases (inflation) and also shrinkflation (smaller content of a product for the same price) but so far no hyperinflation. As consumers and investors, we participate in this process but seldom acknowledge the interplay. For example, when we decide to spend freely at this point in the economic cycle, we are contributing to inflation but not spending at all can contribute towards deflation.

To me, recessions are a natural cleansing mechanism for the economy. Over the course of economic expansions, companies become flush with excess. Meaning that their processes loosen, they hire too many people, they accumulate too much inventory. Recessions are a business cycle’s ‘diet plan’ for companies that need to shed excess but do so reluctantly – with negative growth. Recessions are never fun (the pain will certainly be felt more by those without adequate resources or with less certain employment), but historically they tend to be short-term interruptions between economic expansions. It is accepted that the greater long-term risk to the economy is not recession, but stagflation (slow growth, increased unemployment, and inflation) or even deflation (drop in demand for goods).

Despite headlines to the contrary the ‘tightening’ of monetary policy by the Federal Reserve is essential to economic recovery, which means raising interest rates have to be tolerated to slow down inflation and hopefully without dramatic increase in unemployment.  With that, it is “quite likely” that the unemployment rate will rise “a fair bit” from  where it is now, at 3.6%. If it rises more than a ‘fair bit,’ we could see a period of stagflation.

You’ll likely see headlines through the next months about the last time the US experienced stagflation. Briefly, in the 1970s the onset of stagflation was blamed on the US Federal Reserve’s unsustainable economic policy during the boom years of the late ‘50s and ‘60s. At the time, the Fed moved to keep unemployment low and to boost overall business demand. However, the unnaturally low unemployment during the decade triggered something called a wage-price spiral and hyperinflation. The impact of inflation on our economy will depend on the differential between the inflation rate and wage growth. This is what the Fed is trying to control as it maneuvers for a ‘soft landing’. The higher the unemployment, the greater potential for stagflation.

Stagflation may happen if a recession sets in before inflation has gone down low enough. For example, if unemployment were to go up to about 5% and consumer price index inflation was also above 5%, then that would be a kind of stagflation, though nothing like the degree experienced in the ‘70s. In the near term, we expect the labor market will more likely just cool, resulting in fewer vacancies rather than unemployment. It is likely that we will enter a recession this year and/or in 2023 but hopefully not stagflation. Much depends on how the economy and businesses react to Fed rate hikes.

Before focusing on the unknown future, we should remind ourselves that in the last 20 years, we’ve seen declining interest rates and low inflation, which in turn caused a seemingly never-ending increase in housing prices. This put extra money into our pockets and drove prices of all assets up, which in turn boosted consumer confidence, as people felt wealthier and were encouraged to spend. In addition, during the last 20-plus years every time the economy stumbled, the Fed worked to bail it out – by lowering interest rates, injecting the market with liquidity. This caused the economy and equity market to recover quickly and without much pain. The pain we were spared was stored, metaphorically speaking, in a pain jar (represented in part as increased debt, income discrepancies) awaiting the next crisis. Today, to prevent inflation turning into hyperinflation, the Fed has no choice but to raise interest rates. We expect that this process will take time and likely be cyclical since the Fed only controls a couple of components. Consumers, by their purchases, will play a role in which companies survive this market cycle. The larger goal is for the business cycle to trim inefficient businesses while avoiding hyperinflation, stagflation, and deflation.

Though price drops are considered a good thing—at least when it comes to your favorite shopping destinations – price drops across the entire economy, however, is called deflation, and that’s a whole other ballgame. Large scale deflation can be really bad news.

While inflation means your dollar doesn’t stretch as far, it also reduces the value of debt, so borrowers keep borrowing and debtors keep paying their bills and the economy continues to grow. Modest inflation is a normal part of the economic cycle—the economy typically experiences inflation of 1% to 3% per year—and a small amount is generally viewed as a sign of healthy economic growth. You might have heard that 2% is the Fed’s target inflation rate.

Inflation is also something consumers with assets/resources can protect themselves against, to some extent. Investing in equity markets, for instance, grows your earnings faster than inflation, helping you retain and grow your purchasing power. Protecting yourself against deflation is trickier because debt becomes more expensive, leading people and businesses to avoid new debt. They instead payoff increasingly pricey variable rate debts from prior purchases and avoid new purchases, decreasing growth.

During periods of deflation, the best place for people to hold money is generally in cash investments, which don’t earn much. Other types of investments, like stocks, corporate bonds, and real estate investments, become riskier when there’s deflation because businesses (even businesses with good market performance but with high debt) can face very difficult times or fail entirely.

Overall, in the USA we’ve primarily experienced inflation, not deflation.

As consumers and investors, we don’t control these market components, so what might we do? We focus on what we can control and work to feed the economy while trimming our excess spending.

This is actually a really good time to revisit your financial fundamentals. Do you still have a reasonable emergency fund? Are you spending consciously and aligned with your values and budget? This is certainly a time to re-examine any adjustable-rate debt and determine how to best lock them in. It is also a great time to examine your career and ensure you are professionally valued and not likely in any potential layoff pool. Most importantly, this is a time to get comfortable with what you value and control.

Do not let fear derail what you do. Instead prepare your finances to take advantage of whatever situation presents itself.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Inflation Expectations as of January

On Tuesday, January 11, 2022, Federal Reserve Chairman Jerome Powell called high inflation a “severe threat” to a full economic recovery and that the central bank was preparing to raise interest rates because the economy no longer needed emergency support. Powell further stated that he was optimistic that supply-chain bottlenecks would ease this year and help bring down inflation while the central bank begins removing the emergency support we’ve depended on for years.

The January inflation rate (CPI) is reported at 6.1%.

With U.S. debt approaching $30 trillion and growing at $2 trillion per year The Fed is in a tough spot, they must find ways to fight off inflation. Debt is often a drag on future growth unless the debt is used to increase GDP and stimulate the economy. With higher interest rates and without additional economic growth (GDP), the U.S. government will struggle to cover interest payments given that tax revenues are at about $1 trillion per year. So, I expect aggressive measures will be taken to check inflation.To be honest, there is little agreement on the likelihood that 2022 inflation will be permanent. Some believe that the current wave of inflation will prove to be transitory and expect, at worse, a slowing of the global economy in the first half of 2022. Others argue inflation is not temporary and will be devastating through 2023 (they usually use the 1970’s period as a painful reminder of extreme inflation).

I am cautiously optimistic and believe that in the long-term what matters is our ability to increase economic growth. I also believe that consumers have a lot more influence over inflation than they realize – inflation is not magical or something to be afraid of but rather a reaction to something we consumers encourage or discourage with our behavior. Every time we purchase something despite its excessive price, or we raise the price despite the actual cost, we contribute to inflation. Consumers can practice restraint over consumer discretionary purchases, but it becomes much more challenging when inflation impacts the essentials or basic spending. For example, if your rent increases at 4% (see the chart below), this is not optional so something else needs to be reduced or your income must increase thus fueling inflation.

Percent changes in CPI

In your portfolio we are continually monitoring and adjusting for expected inflationary pressures, volatility, and increased interest rates. Our belief is that with infrastructure funding we’ll reach a high GDP by year-end and a good portfolio outcome. Without economic stimulus we are likely to have a more volatile and less predictable performance this year. You may notice that we added tilts to the portfolio that increased commodities (primarily cereals, materials, energy) and digital/tech assets (like digital supply chain, traditional finance, and fin tech companies) which we expect to do better during inflationary periods. Fixed income is tilted to the short-term and should provide stability if the expected volatility in equity markets materializes.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Inflation, portfolio allocation and long-term goals

The erosion of purchasing power through price increases is referred to as “inflation” (though it has a more detailed technical definition). A prosperous economy needs some inflation to sustain growth but excessive inflation can stall growth and derail a conservative portfolio. This year, we begin paying more attention to the inflation rate as it appears to tick above the Federal Reserve’s target rate (“green line”).

PCE Inflation - Bloomberg 2018 03 31

Source: Bloomberg; As of 3/31/18 US core PCE inflation

 

Inflation is a negative and important part of evaluating portfolio performance but, in the last years, we’ve been lulled into ignoring it (since it stayed below the Federal target rate). To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time.

DOC - Price comparison 1916-2017

Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.

 

In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And in 2017, nine cents would only buy about seven tablespoons of milk. How do we protect your portfolio against this loss of purchasing power throughout our lives and particularly in retirement?

Investing and saving today for future spending

As purchasing power declines over time, investing in fixed income (bonds and annuities), in terms of inflation, increases the risk of outliving your assets. This is particularly exacerbated by fear of market volatility and the practice of increasing fixed income and reducing equity as we age. Although we agree that fixed income allocation is useful to reduce volatility we are not in agreement with tools such as Target Date funds which automatically increase fixed income based solely on age.

Investors know that over the long-haul stocks (equities) have historically outpaced inflation, but you may not know that there have been stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from -0.9% before inflation to -3.4% after inflation. These are a reminder that S&P 500 equity return alone is not always able to protect purchasing power.

Despite these tough periods, one dollar invested in the S&P 500 in 1926, after accounting for inflation, would have grown to more than $500 at the end of 2017 and would have significantly outpaced inflation. On the other hand, the story for US Treasury bills (T-bills), however, is quite different. T-bills are often used as a proxy for a safe fixed income allocation. From 1926 to 2017, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. As you can see in the chart below, one dollar invested in T-bills in 1926 grew to only $1.51 at the end of 2017. Yet a purchase for $1 in 1926 would cost you $14 in 2017! [caveat: other bonds/fixed income did better than T-bills.]

Growth of $1 from 1926–2017

Dow Jones Indices 1926-2017

S&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.

 

Your portfolio with AIKAPA has a fixed income component to protect against loses based on short-term unexpected equity downturn. Instead of increasing the fixed income component of a portfolio with age or as fear of loss grows, we prefer to educate clients on how the portfolio works to both create and protect wealth. We do not encourage reduction in equity exposure based solely on increased age. Even so, we evaluate individual allocation, risk of outliving assets, and risk tolerance annually and encourage clients to let us know if they are anxious about their quarterly portfolio returns. Our target is to provide enough equity for growth/inflation with just enough fixed income to protect and not create anxiety over portfolio changes.

We think that experience with a diversified global portfolio needs to start well before retirement. Combining this experience with ongoing education and open communication we believe is the best way to determine fixed income allocation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com