Between March and April of 2021, core inflation rose at the highest intramonth rate seen since the early 1980s. The question on everyone’s minds, of course, is what comes next. Will inflation tear through the economy and exert pressure on businesses and families? Will it moderate around the 2% annual inflation targeted by the Federal Reserve? Or will it return to the muted levels of the past two decades?
While the question remains open, Delegate believes it makes sense to review allocation strategies for each client in light of the possible course of inflation over the coming five to ten years. While we are often asked if there is a simple formula for protecting a portfolio—and while our usual answer is that it depends very much on the portfolio and the investor in question—we can offer some general guidance.
In short, given the current trend in inflation, we believe that a tilt towards equities and away from bonds can help produce superior risk-adjusted returns over the coming decade. While this does not constitute advice for a particular individual, we believe this point of view is well-supported and can provide a foundation for portfolio management questions.
In this article, we will review some of the post-pandemic pressures that have caused prices to rise in recent months, key variables to monitor, and our view of portfolio allocation considerations for the next five- to ten-years.
Short-Term Inflation: Causes and Complexities
The primary driver of inflation in 2021 is supply and demand pressure. Moody’s estimates that consumers amassed about $3 trillion in excess (compared to standard expectations) savings during the pandemic. Now, as we reemerge from lockdowns, there has been a surge in consumer demand for goods and services. At the same time, supply chain pressures and shortages of key inputs have constricted supply, impacting industries as wide ranging as food, housing, and cars.
As we go into the summer, these two key sources of price pressure will likely persist. We believe there are continued tailwinds to higher demand, including accommodative Federal Reserve policy, elevated unemployment benefits, and transfer payments. Supply factors may also persist over the coming months as global supply chains are reorganized and businesses come back online.
Two Key Variables to Watch
The key question is whether these short-term effects will persist beyond the start of the post-pandemic recovery. Several key variables could provide clues over time, but two are of particular interest in this setting.
The first is wages. Much has been made of wage growth thus far this year, and in both April and May, workers’ average hourly earnings beat expectations for a second straight month. This wage growth appears to be driven primarily by low-wage industries, which are also driving job growth as the economy recovers.
This is an interesting quandary, considering that the U.S. economy is still down about 8 million jobs compared to pre-pandemic levels. There are several potential drivers. Some are pandemic-related, such as childcare shortages, skills mismatches between companies that are hiring and available workers, and the possible permanent retirement of older workers. Another potential influence is higher unemployment benefits, which have potentially changed the equation for lower-skilled workers. Set to expire across the nation in September, 25 states have elected to end these benefits early to help stimulate job growth, a shift that will impact about 3.7 to 3.9 million workers.
Whether these trends persist or are a short-term function of the recovery will remain an open question over the next several months. Wage growth may continue, or it may find a new level and then drop off again. Similarly, measures like signing bonuses, which are included in earnings data, could create a spike now; if employers no longer need to provide them, wage growth could drop off again within several months.
In short, it appears that there are some upward pressures on wages in the short run. It’s not clear how much of it will persist, and we expect we’ll have to watch the numbers over the next half-year to see the impact of elevated benefits.
We also believe it makes sense to keep an eye on possible deflationary pressures on wages. Technology is a major factor: while it might not replace all of the servers in a restaurant, new technologies could help businesses reduce demand for lower-wage staff both in service industries and manufacturing, which could put downward pressure on wages going forward.
If that sounds like a tenuous idea, consider this: McKinsey estimates that we leaped about 5 years forward in digital adoption in the space of 8 weeks due to the pandemic. While some of the necessary measures taken by businesses to survive may be reversed as consumers venture out again, some of that facility for new technology may persist—and if wage pressures continue, we don’t think it would be a stretch for businesses to spend more time and resources on new technologies that can reduce them.
The Federal Reserve
The way that the Fed incorporates and assesses overall inflation pressures will be important.
The Core Consumer Price Index, while useful, does not provide a nuanced picture of the economy, which has seen significant pockets of inflation in some highly specific areas. Some are clearly going to be transitory, while for others we may encounter a longer term shift in trend.
By way of example, auto prices, up about 18% on an annualized basis, are being driven higher by critical microchip shortages and the difficulties in bringing factories and supply chains back online. In areas like housing, we may see a more complex trend in prices given spikes in lumber prices and the question of where (and when) more housing stock is developed. Finally, in areas like wages we believe the jury is very much still out on whether recent jumps will persist among low-wage workers, rise up the income ladder, or sputter out.
The Fed’s reaction to these various issues will very much inform what happens over the longer term. If low interest rates persist and consumers continue to get federal support in the form of direct payments, we believe that, overall, inflationary pressures will likely dominate. When and how the Federal Reserve responds will help to shape both the level and the trend of longer-term prices—and, of course, their impact on economic activity and growth.
Inflation Risk Reduction
Of course, while the discussion of possibilities and variables to monitor is all well and good, we need to shape our client portfolios today.
We believe that a tilt towards equities makes sense given both the current environment and the possibility of higher inflation going forward.
There are two key reasons for this.
First: Inflation is terrible for longer-term bonds
Because bonds are largely considered a “conservative” investment, it’s all too easy to forget that volatility can spike in this area of the market as well. For example, if you had purchased a 30-year Treasury Bond last April when yields hit a low, you would be sitting on an unrealized loss on the order of 25% to 30% today. Yields, which move in the opposite direction of bond prices, moved up about 1% in the past year, which brought prices down significantly (this is a standard feature of bond pricing).
Higher inflation would necessitate even higher yields in order to compensate investors for holding bonds. This, in turn, will exert price pressure on those bonds—especially longer-dated ones. With the possibility of inflation on the horizon, we believe an excess allocation to bonds can expose investors to the potential for negative real returns in this area of the portfolio. That said, an important disclaimer must be added: the appropriate level of allocation to this asset class should be primarily driven by an individual’s needs, rather than an economic play.
Second: Equities can outgrow inflation
Stocks can also be negatively influenced by inflation by putting pressure on margins through rising costs of production, or, of course, through higher wages. That said, in our view stocks provide much better protection from inflation pressures than bonds.
Of course, the immediate counterargument to this is that valuations are pretty high, especially in the hyper-growth areas of the market. However, “high” doesn’t necessarily mean over-valued, at least not on a broad basis. With current economic trends, technology use, and a recovery under way, we think there is still upside to be gained. In the meantime, there are also shorter-term dividends and earnings growth trends to consider—both of these can deliver positive real returns at capital gains tax rates (as opposed to ordinary income), which can help shield a portfolio from the corrosive impact of inflation.
Even if markets should fall, over a period of five to ten years we still favor equities. The potential for growth simply far outstrips that of bonds over a longer cycle, particularly when accounting for higher possible inflation. In that case, we believe that even a 25% to 30% drop in equities—to reference our bond example from the previous section—would still offer a higher likelihood of bouncing back and delivering superior risk-adjusted returns to investors.
The core question about inflation isn’t just what the numbers will be once we work through the immediate post-pandemic period. It’s how people will react.
Keep in mind that we haven’t had significant inflation in the U.S. economy since the late 1970s and early 1980s—you would need to be in your 60s to really remember what this was like. In other words, most Americans don’t have experience with this issue or how to handle it in their lives. This could introduce some unpredictability to the standard models.
All that said, while it appears that inflationary pressures are outpacing deflationary pressures at this time, it’s still unclear as to where we’ll go from here. The Federal Reserve plans to allow inflation to rise before introducing counter measures intended to moderate inflation around the 2% target.
To that end, we will likely see some higher price growth in the coming several years, and to protect portfolios from the possibility we are generally advising investors to consider tilting their allocations to equities and alternatives where appropriate. This should not be a move taken lightly, as bonds provide several important functions. Any such shift in strategy should be undertaken with the proper level of scrutiny, prudence, and care.
Some useful references:
Wage growth, unemployment (please let me know if you need access): https://www.moodys.com/login?ReturnUrl=http%3a%2f%2fwww.moodys.com%2fresearchdocumentcontentpage.aspx%3f%26docid%3dPBC_1287696
More on wages: https://www.bloomberg.com/news/articles/2021-06-09/surprise-jump-in-u-s-wages-gives-inflation-debate-a-new-twist?srnd=premium&sref=c4RUGNV1
McKinsey on Tech: https://www.mckinsey.com/business-functions/mckinsey-digital/our-insights/the-covid-19-recovery-will-be-digital-a-plan-for-the-first-90-days and https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/how-covid-19-has-pushed-companies-over-the-technology-tipping-point-and-transformed-business-forever
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