Behold, the inflation rate has dropped to 3.7%.  It’s projected to fall to 2.7% by the end of 2024.

  

Dread fear of spiraling inflation permeated financial news two years ago, with the number hitting an annualized 9% at one point. Baby Boomers especially feared reliving the double-digit carnage of their youth.  

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“Inflation Fears Are Inflated,” declared our January 2022 newsletter (editor’s note: we told you so!). As the surge would prove transitory, clients did well by not biting their fingernails. We got here sooner than expected and without sliding into recession.  

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A rapid reduction of inflation without recession suggests it’s different this time, despite the wisdom of legendary investor John Templeton, who warned, “The most dangerous four words in investing are, ‘it’s different this time.’" Yet, as long-term investors, we construct “all season” portfolios that factor in history - reasonably but not slavishly so.  

 

Collateral damage

To clobber inflation, the Federal Reserve has imposed the most aggressive interest rate hikes in four decades. If you hear growling noises, it’s the Fed threatening to take more bites out of economic activity — if prices don’t calm down sufficiently.  Catching hell along the way have been interest-sensitive sectors such as real estate and banking — collateral damage in battling inflation. 

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While the world is still shaking off residual effects of the pandemic, supply chain disruptions, massive retirements, etc., have sufficiently receded as an inflationary threat.  Though not closing their wallets, consumers have slowed or flattened spending across various sectors — lessening inflationary pressures. At the same time, inflation would be about a half-percent lower without OPEC’s recent oil price hike.  

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At the gas pump or grocery checkout, the good news is hard to see.  The unexpected pairing of super-low unemployment and declining inflation goes uncelebrated as polls show consumer confidence remains low. Like much else in today’s society, partisanship skews perception, with Democrats and Republicans holding disparate views of the economy.

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The Fed as a social psychologist

Negative sentiment helps thwart the inflationary curse of “irrational exuberance”  in times of overconfidence. The Fed constantly monitors our nation for mood disorders — including despondency during economic downturns - as it decides to hold, raise, or lower interest rates.  

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If the inflation were to drop to 2% by the end of next year, as some analysts expect, the Fed could implement modest rate cuts, which, historically, have boosted stocks and bonds. 

 

Deja vu all over again

A prior generation faced a similar inflation beastie immediately after World War II — when the US pivoted from guns to washing machines. Wartime spending, similar to massive COVID relief, triggered economic disruptions along with scary-high inflation from 1946 to 1948.  In 1949 and 1950, it was zero. 

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To the extent it might be possible, financial planning accommodates the inevitability and variability of inflation (and taxes). This process suggests the degree of investment risk necessary to maintain one’s purchasing power over the long term. Whether an individual adopts that advice — however rational — necessarily depends upon one's temperament.

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Getting “real”

As we consider inflation, investors are mindful of the “real rate of return,” i.e.,  the loss or gain in purchasing power once inflation is accounted for. A look at the historical returns might assure investors who are nervous about inflation:

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Between 1992 and 2022, 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 32 years, investors saw positive returns even after adjusting for inflation.  

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Since 1992, the S&P has posted a real rate of return of 6.9%. Again, that’s after adjusting for inflation. Investors would have doubled their purchasing power every decade, though, of course, this does not guarantee future performance.  

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Third Quarter Results

As the enclosed reports indicate, major financial markets registered negative returns for the past quarter but positive results for the past one, five, and ten years.  Along with your current quarterly investment performance and fee report, we include the Market Review for the Third Quarter of 2023, an overview of how US and foreign markets have performed.