If you are the one in your family who fills up at the gas pump or shops at the grocery store, you have undoubtedly witnessed the rise of prices during the past few months. According to the U.S. Energy Information Administration, the average price of gasoline has risen from $2.248 per gallon in October 2020 to $3.384 in October 2021, an increase of 50.5%.
Maybe you haven’t been paying attention, but that dreaded word, inflation, has made its way back into the regular broadcast of the news in one form or another. Even as they report the facts, the true impact of the rise from 1.75% inflation in Q4 2020 to 6.2% in October 2021 is largely ignored. Your financial advisor might have even started talking with you about the impact of sustained 6% inflation, raising the question, is it temporary or permanent? The result of 6% inflation, if sustained, is a doubling of the cost of living in about 12 years. Just run the numbers. Due to compounding and a longer time horizon, inflation quickly gets scary when we think about the cost of almost anything that we will purchase during retirement.
Let me ask you a question. With which are you more concerned, a) an increase in the price of goods and services, or b) an increase in the price of assets? It kind of depends on where you are in life and whether you already own the asset, doesn’t it? Rightfully, as we go about our daily lives most of us are more concerned with the rise in the price of goods and services. But we may also be concerned about the near-term impact of inflation on our store of wealth in stocks, bonds, and other assets. Making a distinction between the flow of wealth and the store of wealth matters.
I remember my life as a teenager. I regularly visited the Chevy dealer and drooled over a brand new Z28 Camaro sitting on the show room floor. The year was 1969. Its cost was $1900. Today, a quick search pegs the cost of a similar brand-new model (now called a ZL1) at $72,900, an average annual increase of 7.4% over the 1969 price. By the way, the S&P 500 had an average annual gain of 10.9% over the past 50 years.
“Stay tuned… 2022 could be your best year yet!” — Scott Neal
Time horizon becomes a very important factor in any planning scenario, and it takes on a more prominent role when the world is as uncertain as it is today. That’s why we planners stress the importance of time-dimensioned goals, and why long-range planning often needs a different set of assumptions and estimates than planning for more immediate goals. We see a lot of clients and other advisors who have used long-term averages that cover large populations for near-term planning. That is a mistake, in my opinion.
The ABCs of Inflation
There appears to be a lot of misunderstanding about the nature and magnitude of inflation. Some people believe that the Fed can stop inflation by simply raising interest rates. They talk very wgenerically about interest rates, forgetting that the Fed can only raise short term rates and can do very little to impact long term rates. Even buying up long term bonds in large quantities, i.e., quantitative easing (QE), did not raise inflation or interest rates coming out of the Great Recession. The bond market is in charge of long-term interest rates, and these are the rates that truly matter to our future financial security. If inflationary expectations continue to rise into 2022, and if worldwide growth recovers thanks to emergence from the pandemic, we should expect investors to demand a higher interest rate on long term bonds. Stocks are likely to fall in such an environment. As you start looking for safer long-term portfolio returns, remember that increases in yield (i.e., interest rates) result in a decline in the value of your bond investments. Long term bonds are not likely to produce the desired result.
Likewise, there is a lot of misunderstanding about the causes of inflation. Some believe that the deficits created by the spending bills winding their way through Congress are automatically inflationary, and will therefore result in higher interest rates. That is not necessarily true. Remember that deficits of any size are financed by investors buying U.S. bonds. The bond market is likely to stay behind the deficit that funds projects with a positive rate of return. The problem is that Congress has no incentive to even calculate, much less reveal, the expected rate of return on its projects.
So what is the cause of inflation? It is the result of shifts in the demand and supply curves. When the demand curve moves out faster than the supply curve, a rise in prices will occur. In our present case, the supply curve has moved backward while demand has increased dramatically, especially when compared to last year. This situation was quite predictable, but supply is largely ignored in most analysis, that is until it becomes a problem—like now. Anytime someone labels an action as inflationary, you should ask how that action will impact supply and demand. Only when you can answer that question will you know whether it is inflationary. While we are on the subject, what do you suppose the infrastructure spending on bridges and roads will do for the profits of those companies that build roads and bridges? Such an analysis could help you decide where to put your investment dollars.
I am out of space, but I soon want to take up the longer-term prospects for inflation. We could be entering a time of sustained inflation simply due to demographics (fewer workers in industries that serve senior adults while those seniors are living longer). Sorry to end on such a downer, but stay tuned. I firmly believe that 2022 could be your best year yet!
Scott Neal is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. He would love to hear from you at firstname.lastname@example.org or 1-800-344-9098.