Bye Bye Inflation?

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Talk of inflation has dominated the conversation lately, but those days may soon be behind us. Inflation has significant effects on our lives as rising costs erode purchasing power. It can result in a dangerous cycle as reduced consumer spending can contribute to sluggish economic growth and, eventually, recession. Moreover, our “cost of capital” (i.e., the rate we pay for mortgages, personal loans and business loans) rises with inflation, thereby further limiting spending in other areas. Inflation is feared by the federal government and, as we have seen from the U.S. Federal Reserve Bank (the “Fed”), they will fight it aggressively. Actual inflation and “inflation expectations” (where the public thinks inflation is heading) can have significant impacts on investment portfolios. So, let’s review where we’ve been and see if we can gain some insights about where we are headed.

In looking at the year-over-year change in inflation as measured by the Consumer Price Index (chart at right) we see that inflation has been quiet (i.e., running at or below 2% for most of the last decade). Then we saw a dramatic rise after the Covid pandemic with a spike up to nearly 9% before dropping back down to under 6.5%. 

Most economists agree that the peak in year-over-year inflation is behind us as the chart would suggest. The key remaining questions are typically (1) How quickly will it fall? and (2) At what level will it stabilize? We’ve commented in prior articles that government stimulus was unprecedented during Covid. As such, we have no historical analog to offer guidance. No one knows exactly how this story is going to end. As an example, look at what the U.S. government did to the money supply in response to Covid. “M2” which represents cash and checking account balances increased around 40% in only two years (about $6 trillion dollars). While the government tends to blame inflation on Covid, their substantial stimulus clearly played a role and will continue to have an impact along with their future actions. 

So, where do we go from here, and what might be the impacts on investment portfolios? Inflation is generally bad for both stock and bond portfolios. Why? Inflation tends to drag interest rates higher, thereby lowering the present value of corporate earnings, and increases borrowing costs, thereby lowering corporate valuations. Moreover, bonds simply move inversely to prevailing interest rates, so as rates rise, bond prices generally fall. The 10-year U.S. treasury bond (chart below) may offer some clues on the path forward from here. What’s interesting about the chart is that long-term treasury bonds (the 10-year yield) never spiked as much as inflation. For example, yields plummeted with Covid (a perceived deflationary event), but the peak yield once inflation started was only about 50% higher than its 10-year average yield. In contrast, inflation (the CPI) spiked to about 500% of its decade average. The bottom line is that the bond market always viewed inflation as a short-term event and rose to just over 4% with a sky-high inflation reading of 9%. This price action might indicate that it will be tough for long-term bonds prices to fall much below levels seen in late 2022.

Now, with peak inflation and long-term bond yields likely in the rear-view mirror, it may be time to begin adding “duration” (i.e., bonds with longer-dated maturities) back into investment portfolios, depending on one’s risk profile. Longer duration bonds have larger price movements in response to changes in interest rates. So, if one believes that bond prices will rise to bring yields back in line with 10-year averages, we may have a buying opportunity.

The equity picture is trickier. While the Fed has indicated that rate increases may be ending, it is noteworthy that they are still aggressively tightening, and most economists see a recession in the next six to 18 months. Time will tell if now is a good entry point into the equity market. Some sectors and factors are performing quite well. For example, value stocks are making a resurgence as would be expected, and certain inflation beneficiaries are performing well (e.g., energy and commodity producers). 

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