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ACM Journal - Investment Management
21 Apr

Inflation on the Horizon? – Q1 2021 Newsletter

There is a lot of talk of impending inflation lately. Massive amounts of government stimulus during the pandemic have resulted in the largest rise in money supply on record, and the current administration promises far more in the future. Similar measures have been taken overseas, resulting in unprecedented global liquidity. Lots of money in the system, along with the reopening economy, will create a lot of demand for goods and services.

On the supply side, the economy seems ill prepared to meet this rising demand. Supply chains globally have been curtailed because of the pandemic, ice storms in Texas, a shortage of shipping containers, and a clogged Suez Canal. This has made it hard for manufacturers to secure needed raw materials and components to keep their lines moving. Indeed, major automotive manufacturers and others have announced plans to idle plants because of a lack of resources to keep them going.

For those of us who learned that inflation results from too much money chasing too few goods, there is cause to worry.

A rise in short-term inflation is almost a foregone conclusion but isn’t necessarily problematic. Comparing today’s prices in a recovering economy to those last year during a severe recession will result in “easy comps”. That’s analyst speak for numbers that look stronger than they otherwise would because the prior year was unusually weak. Easy comps, by definition, are not sustainable, and often result in hard comps down the road. Thus, it may be that the elevated inflation we see in the coming months is not indicative of a longer-term general rise in prices.

That said, prices have risen across broad swaths of the economy of late. Gas and food prices hikes are often cited, but they are notoriously volatile, and aren’t necessarily indicative of overall inflation. However, a semiconductor shortage has driven up prices for many types of goods, including new and used automobiles. Housing prices are also up materially not just because of a shortage of houses for sale, but also because material costs for lumber, concrete, and steel are up. Even worse, in some cases components aren’t just more expensive, but almost impossible to source. That is true of resin used to make plastics for numerous items. Much of U.S. resin production is located in Texas, and plants were closed during the ice storms in February. This has caused a shortage that manufacturers likely won’t catch up with until 2022.

The Federal Reserve has assured us that the bigger risk to the economy is weak growth and even deflation. They reason that if sustained inflation does appear, they have the tools to deal with it. Though, it isn’t clear to many economists that the Fed has credibility in this regard, as the tools to deal with rising inflation mostly include raising short-term interest rates. Higher rates in a fragile economy can result in a recession, and the Fed has historically been loath to trigger economic downturns.

However, the Fed may not have to step in at all. While all the money printing by the federal government may be creating inflationary forces in the short-term, a load of new government debt will likely weight on economic growth longer term. Harvard economists Kenneth Rogoff and Carmen Reinhart wrote a paper showing the impact that sovereign debt has on economic growth. As debt levels rise, particularly as they rise above 90% of GDP, growth potential slows significantly. U.S. debt to GDP finished 2020 at 129%. It is therefore possible that the growth we experience from the economy reopening will be temporary, and that our longer-term challenges, while significant, will not include inflation. We can look to Japan to see how this sort of scenario plays out.

Of course, it is possible to have both weak economic growth and inflation simultaneously, such as the stagflation we experienced in the 1970s. It is a fairly rare occurrence, and probably requires some sort of adverse policy response to kick in. During the 1970s the policies that resulted in stagflation included tariffs, price controls, and money printing by going off the gold standard. There are certainly analogues today. Tariffs are still in wide use, sanctions limit global supply of goods like oil, and prices may rise because corporations will face rising operational costs from higher taxes, minimum wages, and regulatory costs. These actions could result in a slow-growth, high-inflation economy, but it is far too early to predict that with any authority.

While it is in vogue to worry about inflation these days, it is impossible to know for sure if it is coming. It is also very hard to hedge, and costly if you are wrong. For example, most popular inflation hedges don’t actually do a very good job of hedging inflation. Real estate, many commodities, gold, and even inflation-protected bonds (TIPS) generally aren’t great inflation hedges. None of them have a high enough correlation to inflation to make them solid coincident offsets to inflation. They may help compensate for the adverse impact of inflation on average over time or for shorter periods, but they are not true inflation hedges because their returns do not ebb and flow with inflation with a strong enough relationship.

However, a lot of these investments are not great long-term investments without inflation. Gold, for example, has been a reasonable short-term hedge against inflation, but its returns have failed to keep pace over longer periods. Gold is also very volatile, and low returns and high risk are the opposite of what investors want. So, it is hard to simultaneously hedge inflation and reach for solid long-term returns.

We believe the best approach is to accept that inflation will be part of the investment experience over very long periods, even if it causes some short-term disruptions. A diversified portfolio that includes a healthy allocation to stocks should more than outgrow inflation over time. That doesn’t mean your bonds won’t suffer or that a severe, unexpected inflationary shock won’t cause stocks to dip in the short run. But, for long-term investors, a stable, globally diversified, long-term asset allocation is still the best bet.

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