Inflation is in the headlines again. After years of low inflation rates, the numbers have ticked up over the past few months. In May, the consumer price index (CPI) was 5% above its level from one year ago. This was the biggest number recorded in any month since 2008 and more than double the average annual rate of 2.1% since 2000.
Understandably, people are concerned. Inflation is destructive. It reduces purchasing power, especially for those who rely on fixed incomes. It can create a vicious cycle as businesses keep raising prices to cover escalating costs. To fight inflation, the U.S. Federal Reserve (the “Fed”) may raise interest rates, which slows economic growth. Inflation can also hurt investment markets, affecting different types of stocks and bonds in various ways.
Many investors recall the 1970s and 1980s, when inflation grew to double digits, and the Fed had to wage a long, hard battle to bring it under control. This memory still haunts the markets. So it’s important to look beyond the headlines.
To help you gain a better understanding of this hot-button issue, we explore the forces that drive inflation and provide our perspective on how it affects investment markets. We also discuss what actions investors should take, if any, to protect their portfolios against rising inflation.
What is inflation?
In a free-enterprise economy, prices move in response to supply and demand. Prices are the primary signal for allocating resources. When demand is greater than supply in an industry or sector, prices rise, which attracts new suppliers, bringing the market back into balance.
Inflation is different. It involves persistent and pervasive price increases economy-wide; this, in turn, causes the purchasing power of the country’s currency to decline. Inflation is generally understood to be a monetary problem. When the money supply consistently increases faster than the economy grows, prices rise to fill the gap.
High inflation is destructive, devaluing the currency and distorting price signals. But monetary officials generally view a low level of inflation as an inevitable, nonthreatening sign of a growing economy. The Fed targets an average core inflation rate of 2% per year.
What’s the difference between headline inflation and core inflation?
The CPI measures prices across a representative basket of goods and services. The broadest measure, the all-items index, is called “headline CPI.” Some components of the basket are more volatile than others, especially energy and food. For this reason, policymakers and other inflation-watchers strip energy and food out of the overall index. The resulting “core CPI” provides a better read on underlying inflationary trends.
In May 2021, for example, the energy index was 28.5% above its year-ago level, driven by surging demand for fuel and oil in a reopening economy. This helped push headline CPI to 5% year-over-year. Core CPI was up only 3.8%.
How does inflation affect investment markets?
Over time, stocks are considered a hedge against inflation because company revenues and earnings typically keep pace with rising prices.
Changes in inflationary expectations, however, can disrupt markets. This is because expectations for rising inflation increase the odds of the Fed tightening monetary policy and raising interest rates. Rising interest rates have multiple effects throughout the economy and markets.
Bond prices fall when interest rates go up because the two are inversely correlated. Dividend-paying stocks may be marked down if their yields don’t compare well with higher bond yields. As a general rule, investors consider inflation to be bad for growth stocks relative to value stocks. This is because growth stocks typically have less mature earnings streams than value stocks. More of growth stocks’ earnings expectations are in the future, and they rely more on borrowed money, so they face higher financing costs when interest rates go up.
We may have seen a textbook example of this earlier in the year when growth stocks pulled back and value stocks surged. No doubt this was partly due to natural market rotation as investors took profits off the extraordinary gains in growth stocks over the past year. But inflationary expectations almost certainly played a role.
Are we looking at a new inflation cycle?
On balance, we believe that the recent jump in the inflation numbers will be transitory.
The economy has experienced multiple shocks over the past year. First there was a lockdown, then a reopening. Demand collapsed in many industries, especially service industries, then came roaring back. Supply chains were disrupted. Human migrations took place as people left cities for suburbs and high-tax states for low-tax states, putting pressure on housing markets and building materials. Federal stimulus payments caused a sharp, concentrated jump in the money supply—it grew 32% between January 2020 and May 2021, a rate of increase not seen since World War II.
It would be surprising if these extreme events had not caused unusual price effects. But they could prove to be relatively short-lived. The Fed believes that inflation will moderate over the next few months, back toward its long-term 2% trend. This is our view as well.
What action should I take?
Given how great of an impact that inflation can have on financial markets and the economy, it is natural for investors to wonder whether they need to take action to protect their portfolios against the prospect of higher inflation and rising interest rates. Right now, we believe that it’s best to wait and see how the inflation story evolves. We aren’t recommending specific changes to investment strategies or portfolio positioning at this time.
But we know that every situation is unique. If you have concerns or want to discuss this or any other issue, please schedule a time to talk with our team at Leelyn Smith about ways to strengthen your financial situation in today’s environment.