With headline inflation at 6%, is this now the new normal? And what does this mean for you and your portfolio?
So why do we have this inflation? Really, there are three reasons. One, we’ve been printing money. We’ve needed to do asset purchases, which is code for the Fed buys bonds in the open market as a way to inject capital into the system. This saved the country from a depression when the first shutdown occurred in March last year. It’s always easy to start this money printing., it’s harder to taper. Second, and this has gotten almost no airplay because it’s so bipartisan, it appears, but every economist is choking on the concept, and that is tariffs. When the Trump tariffs came in and they have been maintained by the Biden administration, that basically increased the cost of everything that had a tariff applied. Tariffs are insidious because they end up redirecting supplies to other nations where the margins are bigger. So, tariffs have led to higher prices.
Third, supply constraints. We’ve heard the famous supply constraints. Really this isn’t political. A supply constraint is exactly that. We can’t get enough supply. And really, supply constraints are labor constraints. At every level, everywhere in the world, there’s been labor constraints. In the United States, those labor constraints have been particularly acute in certain sectors of the economy. One area where there’s no reversal is the mass of people in their fifties, especially late fifties, early sixties, who took early retirement when they were forced on the street and decided they didn’t want to look for a new career or a new job so close to the end of their working career. This is where so many of the labor force has disappeared to. A huge number of ladies have decided to not to come back to work because daycare is so expensive. The cost of going to work doesn’t make sense.
So these are the three things that are driving inflation. They all of course have different recipes. So, what’s next? What should we expect next? First, Fed chairman Powell has eliminated the word “transitional” from his definition of inflation and has agreed we need to taper faster. This is beginning to get some momentum, and momentum in inflation is a bad thing. The question now is, is it too little, is it too late with regards to ending the monetary asset purchases?
The risk we’re facing is increased interest rates, which could trigger a market downturn. That isn’t just equity markets, it could be real estate markets, and also at the same time pushed economy into recession. We’re actually in a very fragile place at this point. The second risk and probably the greater risk in some regards, is will long term inflation expectations set at a new normal? So, the bond market doesn’t think so. The spread between TIPS and long-term bonds is very narrow. It doesn’t mean the bond market’s always right, but it does tend to be the best guess out there. Is there even a silver lining to all of this? Well, yes, there is. First all that debt that we created is getting liquidated by inflation. And also, especially for the middle class who tend to have mortgages as a larger portion of that portfolio, those mortgages are being liquidated somewhat by inflation. Just the last two years, you’ve seen a 10% reduction in your mortgage debt in real terms as a result of this inflation.
So how do you protect yourself in this environment going forward? First and foremost, avoid long bonds. We’ve kept our clients away from long bonds now for a few years. Long bonds at these low interest rates will crucify you if interest rates start to rise as a result of inflation. Second, treasury inflation protection securities. They’re a great tool. They’ve had a year. Commodities, commodity investments, commodity-related investments, they’ve had a great year. REITS and real estate, real estate investment trusts or real estate, that’s actually an interesting question. Inflation is good for these products; however, they’ve had a heck of a run up these last two, three years. Refinancing mortgages, you’re running out of time if you haven’t done it already. I’ve refinanced my entire world. It’s about two and a half percent. And I’m not paying any of it down in a hurry. Because with inflation at 6% and a mortgage deduction, you’re paying a net as low as -4%. That’s your return on investment of having a mortgage on your house at two and a half percent. You’re actually getting a better return than you can get on a 30-year government bond. And it’s just as guaranteed.
Finally, equities. Yes, the equity market’s been on the run-up. Yes, it may correct in the near term. But the fact of the matter is, equities are like houses and commodities in that they’re ownership assets and inflation benefits those values over time. The optimal inflation rate for equities actually is about 6%. So don’t be afraid of equities, just remember, what goes up, can go down in the interim. A lot going on. A lot of reason to ask questions. Feel free to reach out if you have any.
Douglas, Jason. “Is Inflation Sticking around? Bicycle Makers Offer Some Clues.” The Wall Street Journal, Dow Jones & Company, 1 Dec. 2021, https://www.wsj.com/articles/is-inflation-sticking-around-bicycle-makers-offer-some-clues-11638374032.
Luce, Edward. “Inflation Always Punishes America’s Left.” Subscribe to Read | Financial Times, Financial Times, 28 Nov. 2021, https://www.ft.com/content/271e53e5-36bc-481f-a6ed-c2de4fb212fa?shareType=nongift.
Smith, Colby. “Jay Powell Looks Past Omicron Threat in Hawkish Pivot on Inflation.” Subscribe to Read | Financial Times, Financial Times, 2 Dec. 2021, https://www.ft.com/content/bbbd46e1-75b3-4882-a2c8-bde7a8df7620.
Smith, Colby. “US Consumer Prices Rise at Fastest Pace in Three Decades.” Subscribe to Read | Financial Times, Financial Times, 10 Nov. 2021, https://www.ft.com/content/5a5a7e5f-4207-4de1-9432-002f96de67bb.