The Inflation Narrative by Joe Stenovec, MS, CFP®
I am seeing headline after headline talking about inflation in pretty much every sector of the economy. It has all started heating up in the past few months and has caught the attention of mainstream media. The Wall Street Journal’s main headline on June 10th’s paper was “Inflation Jumps to 13-year High”.
I feel it, and not just because I have three kids now. I went to Costco last weekend and picked up one of those giant packs of water balloons for the boys. I won’t get into details about how you fill these water balloons up, but it’s one of the greatest inventions of all time (for those who love water balloon fights). But the pack used to be full, and the manufacturer very strategically updated their packaging to include cardboard over one section of the clear plastic front, and behind it was space as opposed to before when it was two or three more! So, it’s not just showing up in prices, but because input costs are rising, they’re packing fewer water balloons to avoid passing a higher cost.
I’m not telling you that story because I want you to know how annoyed I was by this strategy, but to pass on to you what I am reading and hearing from professional and institutional investors when it comes to the inflation narrative that is taking over the airwaves.
I wrote about this back in January in my “Use Signal” write-up regarding the massive increase in the money supply over the past 16 months. A combination of the increased money supply with a never-before-seen economic reopening on top of major supply chain issues. It’s the perfect recipe for higher prices.
Despite all that, the financial markets are shrugging it off right now. In my opinion, the market is convinced that this is all “transitory”. This reminds me of May, June, July of 2020 when the stock market continued to march higher. We were all asking ourselves “how is this market continuing to march higher despite a global pandemic and economic stop?” It’s because the markets were looking past the shutdown. And right now, the market is looking past the supposed “transitory” inflation.
Bond markets tend to be right
Not always, but the bond market tends to be right, which I am using the 10-year US Treasury to represent, and it is telling us this more transitory than not. That is what the bond market is signaling. Yields spiked in the first quarter of 2021 and have slowly been coming back down since then. That spike in yields we saw was the market saying “oh shoot, we might be getting some real inflation” then as we moved past the first quarter and into the spring, the bond market was starting to agree with what the Fed had been saying all along, that it is transitory (at least partially). The Yields rose because inflation means dollars don’t go as far, so the perceived “safe” 10-year Treasury isn’t “safe” when it comes to preserving purchasing power with an inflation spike. Hence, investors started selling and the yield went up (bond prices and interest rates move in opposite directions). Here is the Yield chart to date where you can see the peak market expectations for inflation:
Now the headlines are rolling in talking about inflation, yet the bond market is just shrugging it off because “the market” already expected this.
Is it Transitory? Is it Structural?
Nobody really, truly knows currently and collectively not even the markets. Economists can make their forecasts, but we won’t know how much of this is permanent/structural vs how much will wear off once supply chains catch up and we move past peak reopening (aka transitory). Right now, from what I am hearing it’s too early to say if it’s transitory or structural but would not be surprised if it is partly structural. Jerome Powell, the Federal Reserve Chairman commented yesterday (June 16th) that he believes “some” of the inflation may stick around longer than the Fed originally anticipated. That is not what he has been communicating over the past six months. As I said earlier, they have been calling this temporary for months, but now he may be starting to change his tune. Time will tell, but maybe he’s hinting that it is more structural. The supply chain issues are not something to just shrug off, there are major challenges out there, but it’s natural that will translate to higher prices. The market right now is having a hard time believing that those disruptions are permanent. Hopefully not. The bottom line…nobody knows right now! No matter how articulate the market forecasts you read online are or how smart they sound on the TV. It’s just a guess right now…we just have to wait and see.
What’s the solution?
For one, stay invested, especially in stocks. Companies are innovative, they can navigate an inflationary environment (like fewer water balloons. I as a consumer just have to deal with it… fewer balloon particles to pick up I guess). They will also pass those costs on to consumers, who are in pretty good shape right now. Cash flow has been freed up for a lot of people because they have taken advantage of the low mortgage rates by refinancing, for example. Others may have used stimulus checks to pay off credit cards. Consumers can stomach it, somewhat because of improved cash flow.
But, if we see continued input cost pressure for an extended period, that is bad for corporations and bad for the stock market. Warren Buffet called inflation “a gigantic corporate tapeworm” in his latest annual shareholder letter because it will eat away at profits (kind of gross but I get the analogy). Buffet suggests owning high-quality stocks with strong balance sheets and pricing power. I tend to agree with him – large-cap US stocks, for example with a strong, loyal consumer base.
Second, hedge your portfolio. We don’t go all-in on gold and oil, but maybe reduce some bonds and add a position that is poised to benefit from higher costs, such as commodities or energy.
Be careful with your bonds. Some bonds are more sensitive to inflationary pressures than others so make sure you know what you own (that’s my job on your behalf). By the way, I learned very early on in my career to “know what you own” when it comes to your portfolio and that is a pillar of my due diligence process.
We must be prepared to pay more for stuff, at least for now. The biggest risk right now is that the market starts to change its mind and sees this as more of a permanent condition. From my readings, we aren’t going to know that for some time but if it does become more permanent, the stock market is going to have a hard time digesting that, and we will no doubt experience a turbulent market. In the meantime, there is nothing wrong with preparing for either scenario, then making additional adjustments once the market is more convinced of what’s on the horizon in 2022.
Should I believe changes to your portfolios are necessary I will be communicating those to you in the coming weeks. Until then, maybe start thinking about clipping coupons for your next grocery store visit or be strategic about your travel bookings. In my case I’ll just have fewer water balloon fights, I guess.
Written by me, Joseph M. Stenovec, MS, CFP
The views expressed are those of the author and are not necessarily the opinion of Royal Alliance Associates, Inc. and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed and the accuracy of the information should be independently verified.
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Securities and investment advisory services are offered through Royal Alliance Associates, Inc. (RAA) member FINRA/SIPC. RAA is separately owned and other entities and/or marketing names, products, or services referenced here are independent of RAA.