For over a decade following the financial crisis, economic and market pundits talked regularly about the risks of deflation. What is the Fed going to do to combat the threat of deflation? Are they doing enough? Is the European Central Bank doing enough? What if we get stuck in a deflationary spiral? 

The Fed pushed on a string for 13 years following the financial crisis to get to their targeted 2% inflation level. Zero interest rate policy (ZIRP) and multiple rounds of quantitative easing had limited success in stimulating inflation. Until 2021 – when it was not so much the result of Fed activity but rather a global pandemic that triggered significant supply chain disruptions and labor shortages.

And then the conversation took a 180-degree turn. When is inflation going to subside? Is the Fed going to do anything to curtail this wild inflation? Are we headed toward hyperinflation? How should we prepare for hyperinflation?

And so it goes. Let’s pause and consider a few empirical facts:

• Humans will invariably overweight events of the recent past. This recency bias is a trick that our brains play on us – a useful bias for survival but one which imposes a high cost for investing.

• Human brains are seduced by and drawn to the most extreme predictions – not the most well-reasoned and probable predictions. As a result, airtime and web traffic goes to the forecasters promoting the most extreme views and outcomes.    

• Forecasters do not become famous (and wealthy) by making mainstream predictions. They do so by creating imaginable narratives of extreme outcomes.

• Bad predictions are rarely – if ever – punished. Economic and investment predictions tend to come without a finite time horizon or a long-enough horizon that has them forgotten by the time they could be disproved. Moreover, it is neither in the forecasters’ nor media’s best interest to highlight the overwhelming futility of past predictions. There is – as a result – limited accountability and reputational risk for making extreme (and wrong) predictions.

The net result is that we get overwhelmed with extreme predictions about the future that a) have a compelling narrative attached to them; b) generally overweight the recent past; c) will be difficult to disprove over a reasonable time period; d) will likely be forgotten if wrong; e) will be promoted in the rare case they are right; and f) are generally free to consume but costly to heed.

We are somewhere in the early innings of this unhealthy narrative on the inflation topic. Recent inflation expands. Maybe it becomes hyperinflation. Bonds fall precipitously. The stock market plummets.

It may be helpful to stop here and appreciate the likely triggers of recent inflation, consider the investment implications, and then relax.

The Great Resignation

Since the start of the pandemic, you have undoubtedly been impacted by the unprecedented labor shortage on a regular basis. Industries from restaurants, retail, and schools to airlines, manufacturing, and healthcare have all been hindered by significant labor shortages. With a historic number of job openings (10.6 million as of January 4^th report), hiring remains the biggest challenge for businesses of all sizes.

The labor shortage is far from abating. Nearly 5 million Americans have left the labor force since the start of the pandemic. Some have retired early, some quit to start their own jobs, and some have just exited the labor force because – according to a Joblist poll – their jobs did not provide work-life balance. Whatever the cause, the contracted labor pool comes at a time when surging consumer spending necessitates more workers – not less.

The result has been wage hikes as employers seek to retain and compete for a limited base of workers. New York City subway drivers have been lured out of retirement for temporary 3-month jobs paying $35,000. Desperate restaurant owners in parts of the country have been forced to double their hourly wage ($7.50 to $15.00) to attract and retain employees. These higher labor costs – 4.7% higher than a year ago – have fed into higher consumer prices and added to inflation pressures. Consumer goods and services are 7.0% more expensive than a year ago – the largest rate of increase since the early 1980’s.

As a result of labor shortages, extreme weather, geopolitics, and unusually high demand, inventory backlogs exist in nearly every industry. Global supply chains continue to be constrained as evidenced by unprecedented supplier delivery times, port backlogs on both coasts, and historic shipping costs. The Freightos Baltic Index – which measures global container shipping prices – stands at $9,167 to ship a 40-foot container – roughly 3x the cost at the start of 2021.

How Will Elevated Inflation Be Resolved?

1) Expanded labor force

The reduction of federal unemployment benefits and the child tax credit should aid in expanding the labor force by bringing more persons back to work. The same can be said of a subsiding pandemic which – coupled with higher wages- should bring Americans who exited the workforce at the onset of the pandemic, back to work. That said, the surging Omicron variant has delayed this trend – keeping would-be workers at home to care for sick family members, to satisfy quarantine or isolation requirements, and to take care of school-aged children as schools temporarily revert back to remote learning.

While getting domestic persons back into the labor force is a step in the right direction, another part of the solution to the significant domestic labor shortage will likely come via legalized immigration. Immigration reform within the Build Back Better Act is stalled in the Senate and may not be revived but political pundits believe we may get piecemeal reform in 2022 to help expedite the enormous green card backlog (9 million applications in backlog) and to improve the H-1B visa program.

2) Tighter monetary and fiscal policy.

Fiscal stimulus in the form of expanded tax credits, stimulus checks, and social spending is scheduled to abate in 2022 from 2020 and 2021 levels. Furthermore, the Federal Reserve has already tapered its bond purchases and hinted at three rate hikes in 2022 – starting as soon as March. All else equal, the tighter fiscal and monetary policy should result in curbed consumer demand and reduce price pressure on goods and services.

3) Stabilized Energy prices.

An overlooked but important source of inflation in 2021 was the dramatic rise in energy prices (oil prices rose by 58%) which fed into every other industry. Nearly the entire increase in most food prices in 2021 from fruits to meats to coffee can be tied to the significantly higher cost of transportation. Higher oil prices also contributed to higher input costs for plastics, cosmetics, and textiles.

The OPEC production cuts and extreme weather conditions in energy-producing regions that triggered higher energy prices in 2021 are unpredictable in 2022 but more stable demand should result in more stable energy prices this year.

4) Higher mortgage rates.

While home prices are not directly part of the consumer price index (CPI) measurement, they take on an indirect role by way of the owners’ equivalent rent (OER) measure. OER is easily the biggest component of the inflation measure each month – representing a larger share than food and energy, combined. The hot housing market – which impacted rents and home prices – clearly had a meaningful impact on inflation in 2021.

The housing inventory shortage of roughly five million homes is obviously not something that gets resolved overnight. But the demand side of the equation is likely to be tempered by higher mortgage rates. The average 30-year mortgage rate is now above 3.2% from a 2021 nadir of 2.65%. Homeowners who refinanced to sub 3% rates in 2020 and 2021 will be less inclined to move and reset to a mortgage rate which is significantly higher than what they have now. This does not solve the inventory shortage but it likely reduces the number of potential buyers which should cause home price inflation to subside.

Investment Implications

It is worth reiterating the following points about inflation and the investment ramifications.

1. Price inflation is always a concern we seek to protect for in our portfolio construction process – especially for retirees who do not have the offsetting benefit of wage inflation. It is not and never will be a temporal concern.
   
   
2. The market prices in an expectation for future inflation. The current estimate of inflation over the next 10 years is 1.75% per year (using Treasury yields, inflation swaps, and survey-based measures of inflation expectations).
   
   
3. There is a troubling perception that bonds should be avoided if inflation is imminent. As a reminder, current inflation expectations are reflected in current bond prices so avoiding bonds when inflation expectations are already high is akin to buying home insurance after a fire.
   
   
4. Individual investors who seek to bet on inflation often fail to understand several things but namely that they are not betting on inflation – they are betting on inflation being higher than what the market already anticipates. To be clear – the market already digests that annual inflation over the past year is 7%. This is not a little-known secret.
   
   
5. Inflation is currency specific. That is, asset prices may rise in US dollar terms but not necessarily in Japanese yen terms. As a result, healthy global diversification tends to provide a hedge against domestic inflation.
   
   
6. A diversified portfolio that includes stocks is arguably the best hedge against elevated inflation. Stocks represent businesses and those businesses tend to pass higher producer prices onto consumers in the form of higher consumer prices. Historically, stocks have performed well during periods of higher-than-average inflation.
   
   
7. The Fed is expected to slowly begin raising interest rates in March by one quarter of a percent in response to inflation pressures. The Fed Funds rate is expected to remain below 2.0% through 2026. Although less accommodative than today, Fed policy over the coming years is still anticipated to be very market-friendly.
   
   
8. When the Fed “raises interest rates”, it uses open market operations to target a level for the rate that commercial banks charge themselves on overnight loans – a rate referred to as the federal funds rate.  This extremely short-term rate has a strong impact on the yield of money markets and bank savings accounts but less an impact on longer-term rates. The Fed raising interest rates does not have a direct negative impact on bonds or stocks. Subsequent to the start of the last two Fed rate hike cycles (June 2004 and December 2015), bonds and stocks both experienced healthy gains over the following year.
   
   
9. Value stocks tend to provide an excellent hedge to inflation because of their cash flows and the way that stocks are valued. We overweight value stocks in Golden Bell portfolios not for this reason but it can provide a valuable biproduct if interest rates rise.

Closing Comments

Today’s headlines publicize inflation hitting an annualized rate of 7.0% – its highest level since 1982. Investment pundits will use this as an opportunity to covertly or overtly sell inflation protection. Investment product providers will tout their funds that fight inflation (which may or may not be accurate). Financial news media outlets will use the opportunity to publish scary headlines. Talk show hosts will cite alarming government debt figures and inflation as a reason to buy gold (which – by the way – lost value in 2021 during a period of the highest inflation in 40 years because it is a poor hedge against short-term inflation).

It is worth repeating that the Fed and other global central banks have spent the past 13 years throwing the kitchen sink of monetary stimulus at the economy to get some inflation. Now, we finally have some inflation and conversation has flipped to the other extremes.

We cannot be certain of anything in the future but signs point to the rate of inflation subsiding in 2022 for reasons mentioned above. That said, our investment approach is NOT one of taking a binary view of what will happen in the future and then betting portfolios on that scenario happening. Instead, our approach is to consider all the things that can happen in the market and in the economy and in your life and to diversify assets such that whatever scenario plays out, you will be OK. Even if inflation stays elevated for the next year, it is hard to be better situated than by owning a globally diversified portfolio of stocks and bonds.