Inflation is on a lot of people’s minds, and for good reason.
An unprecedented amount of money has been (and continues to be) injected into the U.S. economy. Logic follows that more money chasing the same amount of goods and services (or in our current economy, fewer goods and drastically fewer services) will eventually result in price inflation.
This is explained by the quantity theory: Money x Velocity = Price x Quantity. When money increases one of three things must happen to balance the equation. Movement of the money must decrease, the quantity of goods must increase, or the price of goods must increase.
In our current environment it’s hard to imagine production outpacing our pre-pandemic levels in the near term—or at a rate that matches the speed of the Fed’s printing press. And while velocity was relatively low through most of 2020 as mass unemployment drove consumer fear, we are now seeing rising consumer spending and confidence.
So that leaves price. The conditions are right for inflation at or above the government target of 2% annually. But inflation is quite nuanced. While it’s probably already built into your financial planning models, there are a few key concepts we think every advisor should keep in mind as you assess the impact of inflation on each client.
1) Inflation Isn't The Same For Everyone
Inflation is often calculated through the Consumer Price Index (CPI). The CPI is a monthly calculation of the aggregate price increase or decrease in certain segments of goods. While imperfect, the CPI is a widely used guide on inflation and the net effects on the average person’s cost of living. And while the Federal Reserve prefers to reference Personal Capital Expenditures (PCE), the government uses CPI as a guide to inform adjustments in pension and social security benefits.
Though there might not be a better alternative for measuring inflation, it’s important to note that the CPI tends to understate the pain felt by rising prices on many—particularly lower-income families whose expenses are dominated by inelastic demand for necessities, such as food, housing, and energy.
It’s also important to note that increased sticker prices are tempered in CPI calculations, offset by perceived product improvements. Many of these hedonic adjustments are of little value to average Americans, and further stack the cards against lower income families who might not need or want the perceived increases in utility that are used to lower inflation figures, and in effect, the financial resources available to them (Social Security and income eligibility requirements for government assistance).
Action Item – We recommend starting with the government-targeted 2% inflation figure in your financial planning. However, given today’s extremes in monetary and fiscal policies, it’s good practice to broaden the range of inflation assumptions in your planning. Run multiple scenarios. At a minimum test your plans through at least two additional scenarios: plus and minus 2% from your base assumption. Essentially, stress test your planning scenarios. This will also help account for inflation that might not be fully captured in the CPI.
2) Higher Short-Term Inflation Shouldn't Impact Long-Term Financial wellness
We currently operate in a market of shortages. The pandemic has caused massive rifts in the global supply chain, hindering both manufacturing and trade. Now that the economy is re-opening, we are seeing the inflationary impact of these shortages.
The price of lumber has skyrocketed (up over 390% over the last year1) creating upward pressure on new home prices. The price of energy, food, and metals are on the rise as well. A microchip shortage has impacted auto prices as well as smartphones and computers. The examples are numerous.
But it’s important to remember that in a shortage market every company in the affected segment has pricing power. Prices become detached from product utility and differentiation. This tends to revert when the shortage is remedied. When the global supply chain is unwound, we expect segment leaders to retain much of their pricing power while budget providers shift back to more affordable price points.
Action Item – Help investors understand that shortage-fueled inflation doesn’t necessarily establish a new price plateau. When goods are scarce, a free market will do what it normally does—companies will compete and set prices according to their value and demand.
3) Deflation Might Follow Inflation
Inflation is certainly coming, but what isn’t talked about as much is the risk for debt-default deflation.
Through the pandemic, governments around the world have been keeping zombie companies afloat—companies so entrenched in debt that government bailouts become the only way to survive. As the stimulus is eventually pared back and the debts come due, we expect to see elevated bankruptcies among highly leveraged companies. This ultimately hurts investors, wiping out their investments in affected stocks and bonds.
Action Item – There are a couple of strategies to prepare for a deflationary period. First, we think it’s important to manage credit risk. We seek low-risk credit options with short durations in markets like these. Further, within our dividend growth strategy, we seek companies with strong prospects for growing their dividend, rather than companies with the highest yields. This helps protect against companies that are “shrinking” from their dividends (and who may eventually cut or reduce their payout).
Second, we advocate educating clients on the value of fundamentally-based investing. We are experiencing a unique time in the markets. Bitcoin has gone through the roof. Millions are gained or lost in meme stocks, like Gamestop. Speculation has seemingly become the strategy of choice for retail investors, a dangerous mentality in our uncertain, stimulus-laden, and overvalued market.
Want to Learn More?
Are you interested in taking a deeper dive into the inflationary and deflationary pressures within our market today? Click here to download our full guide: Inflation in 2021 and Beyond.
1Nasdaq.com, as of May 12, 2021
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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