Inflation is a scourge to all investors and especially retirees! The “nominal” return that investors receive from their investments don’t mean much if the “real” return is not enough to keep up with inflation. A 10% total return sounds pretty good until you realize that a 10% inflation rate would completely neutralize your net wealth leaving you no better off than before! Let’s look at where we have been recently relating to inflation and its impact on markets.
When recent inflation peaked in June 2022 at about a 9% annual rate and the Fed was partly into its rate tightening cycle, capital markets were in a steep decline with stocks (IVV, the green line) down -20% and core bonds (AGG, the blue line) down -10% (see chart below). Since then, stocks have recovered nicely up +19.5% while bonds have meandered listlessly still down about 2% through yesterday. Since we have experienced high volatility during this period and neither market has fully recovered from its inflation-induced losses, the impact of inflation and its related factors on capital markets has been severe.
Academics are not entirely in agreement on the causes of inflation (because if they were, we would not let it happen!) Terms like cost-push and demand-pull get tossed around willy nilly. Some economists say inflation is completely induced by “monetary” conditions such that an increased money supply will inevitably lead to higher inflation; a case where there is too much money chasing too few goods. Others, including the proponents of Modern Monetary Theory, don’t see a problem with flooding the economy with money. But, as we know, during the Covid period, there were huge amounts of Federal money pumped into the economy to prevent economic collapse.
Most thought leaders are in agreement that flooding the economy with money during the covid period was necessary to help sustain the economy during the crisis. However, combining the flood of money with displaced workers, disrupted production facilities and supply chain problems led to a recipe ripe for inflation; combining cost-push, demand-pull and excess money supply. It was thought that perhaps the inflation of 2021 was “transitory” and would go away once the covid crisis passed, but that idea was soon discarded as too simplistic as inflation persisted and firm actions were needed to be taken to quell inflation.
Interestingly, though we are not exactly sure what causes inflation (again, because if we were, we would not let it happen!) we do think we know how to cure it! Efforts to slow down the growth of the economy, whether through raising interest rates or raising taxes, will inevitably reduce “aggregate” demand in the economy and reduce upward pressure on prices. For example, if fewer people are buying houses because interest rates are higher, there is less demand for refrigerators and their prices should stop going up. To help effect this, the Federal Reserve Bank embarked on its interest rate “tightening” cycle in March of 2022.
As seen from the chart below, inflation has certainly come down from its 9% annual rate peak (orange line) in June of 2022. The monthly rates of inflation (the blue bars) started jumping in 2021 prompting the Fed actions. As seen from the chart, since July 2022 the monthly rate of inflation has been consistently below 0.5% and has been under 0.2% (close to a 2% annual target inflation rate) the past three months. Due to lag effects and other external factors, it is not clear that this trend will persist, but to date we have certainly seen inflation quelled.
D&A strives to manage investment portfolios designed to help client achieve their goals. Over time, allocations to stocks have been a good inflation hedge and bonds have been a good diversifier to smooth portfolio risk. Each D&A client has a stock and bond target asset allocation customized to their risk profile as we strive to beat inflation over time.