LEVATUS Perspective | 7 Questions about Rising Inflation Rates with Keith Savard
Keith Savard, LEVATUS Chief Research Officer, answers questions about the recent increase in inflation.
Photo by JD Designs
In June 2021, it was reported that the inflation rate has increased by 5%. Inflation can cause worry for both consumers and investors. Jessica Grande asked Keith Savard, LEVATUS Chief Research Office, some of the most pressing questions on client’s minds..
I just read that inflation is said to have reached its highest level in the past 13 years. What is causing this?
In some sense, the inflation that we are now experiencing is the mirror image of the deflation which took place when economic activity was severely curtailed at the beginning of the pandemic in 2020. With the reopening of the economy, demand for particular goods and services has increased significantly leading to higher prices.
How long should we expect this environment of rising prices to last?
It is difficult to say how long the recent jump in inflation might last. Inflation is a dynamic process and is not simply a one-time increase in prices. Much will depend on peoples’ expectations for inflation going forward, as well as other factors like the growth in monetary aggregates and the future course of macroeconomic policies. At the moment, the conditions which might contribute to a revival of inflation are not especially worrisome. However, the situation remains fluid and it is important to pay attention to key indicators like labor costs.
How does this period of inflation compare with the 1960s and 1970s? Are there lessons we can learn from that time? Is there anything unique about this period of inflation?
No two periods are exactly the same, so it is hard to make meaningful comparisons without going into some detail. Suffice it to say that the 1960s and 1970s were a period where fiscal expenditures were high because of the Vietnam War and programs like the Great Society designed to eliminate poverty and racial injustice. The period was also characterized by rising labor costs and commodity prices highlighted by the Arab oil embargo.
All periods of inflation are unique in the sense that periods of sustained inflation are rather uncommon in economic history. This is one reason why inflation receives a lot of attention in the press and from economists. What economists and policy makers learned from the period of the 1960s and 1970s is that inflation can become self-perpetuating if expectations of higher prices become engrained and policy makers are remiss in making the hard decisions required to subdue inflation. It took a courageous act in the early 1980s by Federal Reserve Chairman Paul Volcker to slam on the monetary policy brakes and drive the economy into recession in order to break the cycle of inflation.
Do you think this will cause the Fed to tighten monetary policy more quickly than expected? Are there any other actions being taken to curb the rise in prices?
The Federal Reserve is taking a calculated risk by stating its intention not to tighten monetary policy in the current environment, believing that the current inflation situation is transitory. Federal Reserve officials seem convinced for the moment that maintaining an accommodative monetary policy to increase the likelihood of a sustained economic recovery outweigh the risks of triggering a bout of more persistent inflation.
Although the Federal Reserve is currently shying away from monetary policy tightening, it nevertheless is actively engaged in trying to influence inflation expectations. This is being done by commenting in detail on the nature of recent price increases and linking those to the ongoing recovery and recalibration of the economy from the pandemic. In addition, senior Fed officials are enticing Fed watchers with comments alluding to the possibility that changes in the operation of monetary policy could be outlined at the August conclave of central bank officials and academics in Jackson Hole, Wyoming.
Is this just a U.S. problem? Are there other regions of the world being affected by inflation and if so, what are they doing?
The set of circumstances associated with the economic recovery from the pandemic, including recent prices increases, are not limited to the United States. In many ways the United States has fared better than many countries because of the innovative and flexible nature of the economy. Moreover, U.S. authorities have been quite proactive in committing substantial resources to address the multifaceted problems connected to the pandemic.
Like the United States, Europe has experienced rising inflation in recent months, although the year-on-year increase is lower with the European Central Bank announcing that it will maintain its accommodative policy for the foreseeable future. Producer prices in China accelerated at a double-digit rate in May from a year earlier, giving the authorities more reason to remain cautious in providing stimulus to the economy. Inflation in emerging market countries covers a wide range of increase with the worst cases suffering from unorthodox policies tied to misguided political leadership. Overall, emerging market countries have performed well in allowing for adequate policy flexibility to deal with the recovery from the pandemic.
What are the risks to my portfolio in an inflationary environment? Are there any potential upsides?
Historically, equity portfolios have done well in an environment of moderate inflation. According to LPL Financial Research, when yearly U.S. inflation has been in the range of 2 percent to 4 percent, the S&P 500 index has experienced an average annual return of 9.2 percent. When inflation has jumped to between 4 percent and 6 percent, the rate of return has been 8.7 percent. Once inflation rises above 6 percent, the return on the S&P 500 drops to only 3.3 percent.
Looking back, commodity stocks and so-called value stocks have outperformed during periods of inflation. A similar pattern has developed as well in recent months. However, concerns about inflation are not the only influence on these stocks. The extensive use of index and algorithmic trading have helped to drive momentum and volatility in equity markets creating a dynamic of its own.
How has Levatus structured my portfolio to hedge against inflation? Is there anything additional I should be doing now?
Client Funding portfolios have three objectives, liquidity, positive annual return, and purchasing power protection. These objectives are designed to provide cash flow flexibility, address risk budgeting and protect against inflation. Funding portfolios currently have holdings in highest quality fixed income instruments. These positions have staggered maturities, so that the overall portfolio will benefit from rising interest rates associated with accelerating economic growth and inflation. At this point, the average maturity of the portfolio is quite low, so if rates rise unexpectedly, portfolios will be positioned to capture incremental yield by redeploying the proceeds of maturing bonds at higher rates. In addition, the cost of borrowing tends to rise more for corporate issuers in an environment with incremental risks, including periods of rising inflation (which means that corporate bond prices go down). For this reason, the current Funding portfolio is not positioned in corporate bonds.
Having lived and invested through the 1970s, Warren Buffet has written extensively about the impact of inflation on people, portfolios, and businesses, calling inflation a “tax with an amazing ability to consume capital.” While we do not believe we are entering into the type of inflationary environment Buffet experienced in the 1970s, even moderate inflation does impact portfolios. With inflation, hard assets are beneficiaries, companies with pricing power are beneficiaries, companies that produce good or services that can create efficiencies for other businesses are beneficiaries, companies with more limited labor cost exposure are beneficiaries. Companies with limited pricing power, high price to earnings multiples and weak balance sheets (think lots of debt that becomes more expensive as interest rates rise) are at the other end of the spectrum.
The LEVATUS investment process for growth assets emphasizes factors that give visibility into growth sustainability. These factors include margins, balance sheet strength and secular tailwinds. Client Growth portfolios have therefore always emphasized companies and industries that tend to have stronger pricing power. While we view this as important in any environment, it becomes particularly so when inflation hits. In addition to addressing the runway for growth, this approach creates ballast against the structural risks of inflation by focusing growth portfolios on companies with strong pricing power (ability to increase prices on their good if their input cost move higher) and less sensitivity to rising interest rate.
Separately, we view client real estate holdings and other hard assets as important parts of overall portfolio balance.
ALIGNING LONG TERM CAPITAL WITH LONG TERM OPPORTUNITIES
I have a few more questions …
August 2024 started with a swift drawdown in markets. As with many such corrections, a major contributor was leverage.