“How are we going to pay for all of this?”
“All that money being given out is going to drive prices up.”
We’ve written about the Biden administration’s tax plans, so today we will address the concern of impending inflation. I say impending, but some would point out that inflation is already here…just look at the prices of goods like gas or lumber. We know that prices increase over time, but should investors be especially concerned about inflation right now, given our current environment?
WHAT TO KNOW ABOUT INFLATION
First, remember that all this information about stimulus, national debt, and government proposals is public information. The market is smart and efficient – it knows all this information too. It’s already built into current market prices. If high inflation is a possibility, the market is already considering that.
Second, inflation over time is expected. That’s why it’s important to save and invest for the future in the first place. Things get more expensive over time! Economic data suggests recent inflation is as high as 4.2%, though the average for 2021 is still only 2.5%. Bond market data suggests an expected annual inflation of 2.6% over the next five years. The historical average is around 3.2% per year.* None of these numbers are extreme compared to what the US has experienced in the past. Inflation in and of itself is not bad, and we have always dealt with it.
Finally, the Federal Reserve has a history of being able to manage inflation. Consider that interest rates are historically low right now. The Fed could raise rates to help combat runaway inflation. Plus, a rate increase would also be welcome news for bond investors over the long-term. The point is, the Fed can control inflation pretty well and has the tools to do so.
HOW INFLATION AFFECTS INVESTORS
We expect inflation, but what if it’s higher than expected inflation? While that might seem like a concern that could upset the economy and the market, the truth is that stocks are the best way to combat unexpected inflation. It actually makes sense – higher inflation means higher prices. Prices go up when demand is high, demand is high when people are spending money…all of these are ingredients for good stock performance. Here is some historical data from that 1970s-80s, the highest period of inflation we’ve seen since the Great Depression:
As you can see, high inflation coincided with high returns. I don’t know about you, but I’d sign up for 15.6% annual return over the next 12 years in a heartbeat. Stocks provide the best hedge against inflation and are the best way to preserve and grow your purchasing power over time.
What about bond investors? With interest rates (and subsequently bond yields) so low, would bond investors be hurt by higher inflation? It’s certainly possible. Those who have a significant amount of their investments in bonds may want to look at TIPS (Treasury Inflation Protected Securities). These special bonds are linked to inflation and can provide good return in the event of unexpected inflation. However, if inflation is in line with expectations, or lower than expected, you would be better off not owning TIPS.
At the end of the day, TIPS can serve as a good diversification tool for bond-heavy investors, but stocks are still the best remedy for inflation. This is a good reminder that the market temporarily declining is not the biggest risk most investors face; it’s actually inflation risk – the risk of not earning enough to preserve their purchasing power. This is why most investors need at least some allocation to stocks over the long term, and serves as yet another reminder not to make any rash decisions based on the news of the day.
* Data from the US Bureau of Labor Statistics, USInflationCalculator.com, and Charles Schwab.