In the last two installments of the Five Seasons Financial Planning blog, Articles on Wealth Management Topics, we spent a fair amount of time discussing inflation and the risk it poses to retirees' finances. If anything, inflation has become even more of a concern since then. The most widely used measure of inflation, the Consumer Price Index (CPI), rose 6.2% in the year ending in October, easily surpassing September's 5.4% increase. This most recent bout of inflation is the worst that we've experienced since July 2008, a fairly auspicious omen for investors given what was going on in the financial markets back then.
While October marked the fifth straight month that consumer inflation attained a rate of at least 5%, supply chain disruptions and labor shortages have made price pressures even worse farther back in the production pipeline. Producers of goods and services have experienced an inflation rate of 8.6% during the last year. Whether producers are willing and able to pass along these price increases to consumers will go a long way to determining if this current inflationary episode has staying power.
As with so many economic and financial developments in today's global world, what happens outside of the U.S. in terms of inflation will also play a major role in what consumers and investors here experience. In this respect, the news is fairly good. Amongst the five countries from whom we import the most - China, Mexico, Canada, Japan and Germany in that order - only Mexico currently has an inflation rate as high as ours. And in China and Japan, the second and third biggest economies in the world, consumer inflation is still less than 2%.
Investing in an Inflationary Environment
The current level of consumer inflation far exceeds the relatively benign 2.4% average rate of the past few decades. In fact, inflation has been so well-behaved for so long that investors could be forgiven for not knowing how to respond to it. You'd have to go back as far as the early '80s to find inflation above 5% for any sustained period of time.
Among the major asset classes, it's not surprising that bonds - with their fixed coupon payments and predetermined principal amount repaid at maturity - historically fare poorly in inflationary environments, when purchasing power is eroding. The current financial markets are extremely strange in this regard. Although most investment-grade bond sectors have posted small percentage losses in the year to date, almost all bond sectors still yield less than the inflation rate we're currently experiencing.
For the most part, stocks in developed markets have also generated disappointing returns during inflationary regimes. High and rising inflation is indicative of a less stable economic environment, and stock investors shy away from uncertainty and unpredictability. Meanwhile, corporate input costs usually rise more than output prices, thereby squeezing profit margins.
In this respect equity sectors that are particularly exposed to the individual consumer - e.g. the technology, consumer durables and retail industries - have in the past been the worst performers. And while some equity sectors (such as the energy sector) have performed better than others during inflationary periods, none does well on an absolute basis. However, on the plus side there is strong evidence to suggest that diversifying into international stocks pays off during these times.
If you concluded from the preceding paragraphs that the traditional 60-40 portfolio (composed of a 60% allocation to stocks and a 40% allocation to bonds) offers little protection during inflationary regimes, then give yourself a gold star. Exposure to asset classes other than these two becomes particularly important during these episodes.
Commodities have historically been the best inflation hedge, so it should come as no surprise that this asset class has generated handsome returns this year after a long period of disappointing performance. Collectibles also perform very well when inflation is high. Real estate tends to be a mixed bag as higher rents and input prices (land, labor, copper, lumber, etc.) are offset by higher financing rates.
Debt Management in an Inflationary Environment
Speaking of financing rates, being in debt in an inflationary environment is beneficial if the interest rate on your debt is fixed. As a fixed-rate borrower, you have agreed to pay a fixed amount of money every month for years into the future, as in the case of a car loan, mortgage, or student loan. On the other hand, inflation steadily eats away at the purchasing power of these payments through time. As a result, you benefit as each monthly payment constitutes less and less purchasing power being sacrificed.
As you might imagine, those with relatively more fixed-rate debt outstanding stand to gain the most from this by-product of inflation. This was the topic of Heidi Rivera's recent article in Money magazine, Why Debt-Ridden Millenials Should be Cheering for Inflation, in which I was quoted. This is the bright side of inflation.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.