By Ryan Dolan
Inflation. We are slapped in the face with this new and unfamiliar reality on a daily basis-at the gas pump, the grocery store, trying to make summer vacation plans. Prices are up and quality is down. Financial markets are starting to feel the inflation threat-with stocks and bonds both plunging. While the impact on the red hot housing market has to this point been muted, surging rates, should they continue, present a real threat.
The big (and it must be stated at the outset) and largely unknowable question: is this inflationary surge temporary or structural? The answer will have profound financial implications.
Throughout 2021, politicians, central bankers and investors believed (or wanted to believe) that this surge in inflation was a momentary, short-lived result of Covid stimulus and supply chain issues. They were wrong. Kevin Warsh, a highly respected economist and former Fed official (don’t hold that against him), thinks the risks of inflation getting away from policymakers is high:
“Inflation is the sincerest form of fakery: a surge in the cost of living that robs Americans of the fruits of their wage gains. An incomparable asset boom predicated on perpetually low interest rates. Alchemy for an overly indebted nation. Inflation is a choice. It’s a choice for which the Fed is chiefly responsible.”
“Leaders in Washington are unnerved, and they should be. Their actions so far have been unequal to the challenge.”
“Inflation is a clear and present danger to the American people. Extraordinary excesses in monetary and fiscal policy caused the inflation dragon to resurface after 40 years of dormancy.”
Few living and investing today have experience operating in an extended inflationary environment. The behaviors, tactics and mindset perfectly suited to the low inflation/low interest rate environment we have grown accustomed to, would be exactly unsuited in a rising one.
Here are some thoughts on trying to adjust to the specter of a new inflationary reality:
Think in real, not nominal terms
Over-indebted governments use inflation as a silent tax to work down their debt load. Inflation is more opaque, the responsible party less obvious than a politician taking away government benefits or raising taxes. But the financial impact on citizens is every bit as real.
Think of all the ways governments can use inflation to work away debt. First, they understate true inflation, keeping their finger on the proverbial scale-be very suspect of “official” inflation numbers-assume the true number is higher. By understating inflation, governments keep their funding costs (Treasury rates) artificially low. The trickle down to citizens are numerous: too much money chasing too few goods leads to surges in their day-to-day costs; Social Security Cost of Living Adjustments don’t keep pace with inflation, eroding their real value; the tax deferred amounts you can contribute to retirement accounts and HSAs go up in nominal terms but down in real terms; the real amount you can gift tax-free also falls. The ways to swindle citizens are limited only by the deviousness of the bureaucratic mind.
As nominal prices spiral higher, for example home prices, the tax “take” goes up. Whereas most Americans wouldn’t have to pay capital gains on a house sale a decade ago, now more and more have gains in excess of the $500,000 home sale exclusion, even though inflation played a large role in that increase.
Look at Treasury bond holders, who are loaning the government money at negative real interest rates. That’s bad enough, but consider they are paying tax on nominal interest income-thereby further exacerbating their true net losses.
Think your income went up 15% in 2021 vs 2020? If the inflation rate was 7% as the government says (it was likely 10% or more), much of that gain was illusory. Worse, like capital, all of that nominal income is taxed.
Though it can be depressing, force yourself to think in real, not nominal, terms.
The primacy of a high savings rate
For those who were already having trouble saving before, the onset of inflation is having a big negative impact. It’s why I continually hammer clients on keeping spending in line and work with them continually to build and maintain a robust savings rate-it helps insulate you from many forms of financial threat-including inflation.
A high savings rate is the absolute cornerstone of financial security. A 25% savings rate can handle a sustained inflationary shock. A 5-10% rate cannot. Reviewing client spending patterns, the typical household saw spending increases of 10-15% from 2020 to 2021. While part of that is an unfavorable comparison with artificially depressed pandemic spending in 2020, a considerable portion was inflationary. If you don’t focus on cash flow and savings, I can almost guarantee your increases were higher.
There is never a more important time to target increased savings/decreased spending than in an inflationary environment. If you’ve let your spending discipline grow slack, it’s time to refocus and get accountable. If this inflationary cycle progresses, it will bury many low-saving Americans at all income levels.
Investing implications
The last prolonged inflationary cycle in the US occurred from the late 1960s to the early 1980s. At the start of that period, asset prices, debt levels and confidence were high. By the end nearly, stocks, bonds and real estate were beaten down, debt was a four-letter word and the American psyche was battered and demoralized.
The conventional wisdom of stocks as an inflation hedge were adamantly disproved in this period. From 1968 to 1982, the aggregate real return of the S&P 500 was -63%. Think about that: you have $1 million, and fifteen years later, after 15 years invested in stocks, the purchasing power of that portfolio fell to $370,000. Ouch! That will test the mettle and conviction of even the most patient buy-and-holder who thinks they have a rock solid risk tolerance today.
Historically equities do best in low and falling inflationary periods. Conversely, deflationary environments and high inflation environments (say over 5-7%), have historically been bad for equities. Also, asset valuations matter. Cheap equity markets tend to be far more inflation-resistant than dear ones. This applies to real estate as well. At a time of bubble-like valuations in stocks and real estate, don’t get too seduced by the inflation-resistance of these assets.
How should you structure your portfolio? Well, bear in mind that the exact right portfolio for a low rate, low inflation environment (very high equity exposure, a tilt to growth stocks) would be badly impacted by inflation. Did you shoot the lights out in 2021? Chances are you are getting spanked in 2022. Look at your compound returns for the two years-how are you doing? Chances are you are down on a net basis.
You should have a diversified portfolio that is built to your needs and attributes and is balanced against the range of outcomes which could occur. At the moment, this range seems particularly wide to me. Having some inflation resistant assets, and tilting away from ones that need low inflation/rates seems prudent to me.
Debt
Generally speaking, having some fixed-rate debt during an inflation cycle makes sense. As inflation increases, the real value of the debt decreases, while your financing cost remains unchanged-a great combination. I’ve long been a strong proponent of the fixed, 30 year mortgage. It’s an instrument that gives the debtor lots of positive optionality: If rates fall, you refinance at a modest cost; should they rise, however, you keep the mortgage for decades, reaping the benefit.
I am not a fan of adjustable rate debt-particularly now. Falling asset prices financed with constantly increasing funding costs is a brutal combination that I don’t recommend experiencing first hand.
The last extended inflationary cycle was in the 1970s-a long time ago, a time of significant financial (and societal) change. From a financial perspective, it was a very challenging period to build and sustain wealth. But there was a silver lining in this dark cloud:, by its culmination in 1982, stocks, bonds and real estate were generationally undervalued, interest rates and inflation peaked and were beginning a 40 year descent, and debt levels in the economy were trivial. It was a glorious time to have liquidity, a clear head, and the willingness to invest.
Getting there in one piece financially, was the hard part.