Will Inflation Hurt My Portfolio?
First Quarter 2022 Newsletter
Quick! What’s the price of onions in India? If you lived there, you could cite the price faster than Americans can quote the cost of gas.
“In India, very little can be cooked without onions — including electoral success,” observes the Indian daily paper, The Hindu. “Time and again onions have played a major role in swinging votes and bringing the ruling politicians to tears while giving their opponents a taste of success.”
Here in America, gas prices are a blunt tool for gauging inflation and our economic wellbeing. In a recent political ad, a politician is shown fueling his SUV while howling about the price at the pump. The would-be senator, himself a multi-millionaire, complains of having to shift from premium to mid-grade gas.
Partisan noise aside, March did deliver a harsh government statistic: the Consumer Price Index. This universal measure of inflation is up 8.5 percent over the past 12 months, the biggest jump in 40 years. Anyone who has recently filled a gas tank or a grocery basket, onions and all, may say, “Duh!” The pain is real and pervasive, especially for those on limited income.
Inflation and War.
Since our last quarterly newsletter, Russia’s invasion of Ukraine has shocked our conscience and weighs on our hearts. This unmitigated evil casts uncertainty over the geopolitical order, not just the direction of the economy. With inescapable parallels to World War II, Russian aggression guarantees increased global military spending, hastened development of alternative energy, and a renewed look at nuclear power.
Before the war, as the covid pandemic was unwinding, there were inflation-inducing factors of labor shortages, shipping bottlenecks, and other supply chain disruptions. Lags in energy production had already increased food as well as transportation costs.
Plus there are hidden reasons for food price surges. California is in a three-year drought that has reduced agricultural output.
Avian flu required poultry growers to “depopulate,” that is, kill, 29 million birds, mostly egg-laying hens.
With additional feed grains diverted from livestock and to ethanol fuel production, we, in turn, are paying more for meat, poultry, and farmed fish.
In a recent political row over immigration, produce trucks arriving from Mexico had been delayed by the State of Texas, temporarily sending the cost of avocados, etc. through the roof.
Taken together, these inflationary factors are likely to be transitory, not entrenched, although price surges might feel permanent and pervasive.
Less clear is how long the war will further stress global supply chains. Normally, Ukraine produces eight percent of the world’s wheat and 13 percent of its corn. Now Ukrainian farmers are unable to plant crops.
Lost production means higher prices paid by developed countries and food shortages - perhaps famine - in developing countries. In the next growing season, other nations will increase grain production, but not soon enough to prevent the present humanitarian crisis.
Ending Russian aggression is only a question of when. In the meantime, we can be confident of solidified Western resolve to halt Putin. The United States and European Union nations have vastly more military capability than Russia.
In terms of economic might, the US and EU have a combined global GDP ten times greater than Russia’s. Going into the war, Russia represented three percent of global GDP. Under the weight of Western sanctions, the Russian economy will shrink by at least 15% this year.
Western companies continue to exit Putin’s Russia; those staying are subject to naming and shaming.
Interest Rate Sensitivity.
The Federal Reserve is now more concerned with inflation than unemployment. Therefore, the Fed raised its key interest rate by one-fourth of a percentage and may raise it further. Correspondingly, the 30-year fixed-rate mortgage recently jumped more than two percent. Is this an overreaction by lenders or a signal of what’s to come?
To tamp down inflation, housing costs must come down, even as it causes pain along the way. The cost of housing makes up one-third of the Consumer Price Index, the key inflation measure.
Acutely sensitive to interest rates, the housing sector is beginning to cool down after cramming a decade of normal price appreciation into the past two years. The overheated housing market had exhibited the effects of both “cheap” money and a persistent housing shortage.
Surprisingly, a housing glut may emerge soon, according to The Economist. Presently, 1.6 million homes are under construction, the most housing starts since the 1970s and twice the number of homes for sale at the end of 2021.
Bottom line: housing’s contribution to high inflation may yet prove to be transitory, not entrenched.
Inflation Appears to Be Headed Downward.
Economist and columnist Paul Krugman sees additional signs that inflation may be coming down over the next few months. He cites the “bullwhip effect”; this occurs when the supply chain overcorrects for empty store shelves that are subsequently oversupplied. Prices then remain level or fall.
“Retailers are sitting on unusually large inventories. Car lots are filling up. Demand for trucking is falling quickly. International shipping rates seem to be coming down,” Krugman explains. Crude oil prices are barely above their pre-war level and the wholesale price of gas recently declined 60 cents per gallon from its peak.
The labor-friendly economist concedes that quickening “wage growth is unsustainable and inflationary.” For it to recede, he concedes, “I hate to say this … we need to see unemployment to tick up at least a bit.”
Mass Psychology Affects Inflation.
As experienced in the 1980s, consumer expectations of “spiraling” inflation were somewhat self-fulfilling. It was an era of double-digit inflation, and there appeared no end in sight. Consequently, workers demanded ever-higher wages to meet the ever-increasing cost of living.
Producers, then as many do now, passed on increased costs – and more. Under the cover of gloomy inflation expectations, producers almost had permission to raise prices in excess of the rate of inflation – thus fattening profits.
Recent consumer surveys show a bright spot regarding inflation expectations. We collectively anticipate high inflation to come down significantly over the medium term. This should temper wage-price growth.
Inflation's Impact on Portfolio Returns.
In advising our clients, we highlight inflation-adjusted returns, the “real rate of return.” This shows if you are losing or gaining purchasing power. For example, if your portfolio grew by 10 percent while inflation increased by 4 percent, your real rate of return would be 6 percent (10 - 4 = 6).
Stocks Historically Beat Inflation.
A look at the historical returns might assure investors who are presently concerned about high inflation.
Between 1991 and 2021, one-year stock returns have fluctuated widely, and some of the weakest returns occurred when inflation was low. So, there’s a weak correlation between inflation and stock market performance. For 24 of the past 31 years, investors saw positive returns even after adjusting for the impact of inflation.
Since 1991, the S&P has posted a real rate of return of 8.5 percent. Again, that’s after adjusting for inflation. Going back to 1926, the real rate of return is 7.3 percent.
At those rates of growth, investors would have doubled their purchasing power about every ten years. (Past performance is not a guarantee of future results.)
Recent Market Returns.
Since the beginning of the year, we have seen significant declines in financial markets, both stocks, and bonds, domestic and foreign – almost all asset classes are down. Given the inverse relationship between bond prices and interest rate movements, bond portfolios have dipped in value, at least for the time being.
When stocks and bonds will rebound, we cannot say. As long-term investors, we do construct “all-weather” portfolios intended to moderate volatility while participating in market appreciation.
What's New in Your World?
In the enclosed quarterly report, you will see a summary of your financial plan. Possibly this information should be updated. We appreciate your help in maintaining this “dashboard” in order to accurately track your financial progress. We welcome your call to update our data and to note other changes in life.