Inflation is the percentage that prices for goods and services are rising. When inflation increases beyond the median level, it scares many investors. Inflation reduces the purchasing power of your assets, unless, of course, your assets are growing faster than inflation. That’s why the “real return” on your assets, which is the “nominal” investment return on those assets minus inflation is where you need to focus. Your real return shows you whether your purchasing power is increasing or not.
The media and industries selling certain products have created a huge fear of inflation. Headlines like “Americans’ Inflation Fears Reach a Fever Pitch as Consumer Prices Rise” or “Inflation Fears Rise as Prices Surge for Lumber, Cars and More.” Of course, fear sells- in the media and with some people buying the hope that gold, commodities and other “silver bullets” might protect them from the “horrors” of inflation.
Let’s first take a deep breath and look at where inflation is and where it is expected to be in the future. And, then, let’s focus on real investment returns during periods of high inflation.
2021 inflation is roughly 5.3% year to date. 70 million Americans receiving social security will get a 5.9% increase in 2022. Food and shelter have produced about half the increase; followed by energy and gasoline. The Federal Reserve works to keep a healthy inflation rate, currently a 2% target. Falling prices, though seemingly a good thing, may actually lead to deflation. During deflation, prices can be lower, but this may produce stagnation in the economy or even recession.
COVID has been the primary cause for the current inflation. COVID disrupted supply chains and labor markets. As a result, government’s response, to avert a deflationary bust in the economy, pumped in trillions of dollars into the economy. This funding produced two straight years of $3 trillion deficits and added almost 3% per quarter to GDP. This tremendous fiscal tailwind through 2021 will likely turn into a headwind in 2022 according to the Hutchins Center of the Brookings.
Here are some key reasons for inflation abating:
- Demographics -Aging Americans and declining population growth put downward pressure on aggregate demand.
- Technology- Innovation in this sector is generally deflationary.
- Inequality- Less money in the hands of those with a greater propensity to consume again lowers the aggregate demand.
- Globalization- puts downward pressure on domestic wages and prices.
The forecast is for inflation to start to abate in mid to late 2022. This seems to square with yields on 10 year treasuries at 1.6% and 30 year fixed rate mortgages still around 3%.
But, what if the forecasts are wrong and higher inflation stays with us longer? Ok. Let’s take a look at real returns over time.
Historically, from 1920-2020 during periods of low, medium and high inflation, U.S. Stocks have exceeded inflation and produced an annual real return of 8% (10.6%-2.6%) The highest real returns generally occur when inflation is 2% to 3%. Of course, returns are impacted not only by inflation but also by the timing of the economic cycle and government fiscal policy.
Turning to high inflation, here’s a chart from Dimensional Fund Advisers showing average real returns for U.S. stocks in years when inflation was above the median. The overall average is a 4.9% real return.
Yes, when inflation is high, the real returns may be lower than average, but the nominal returns over time will likely still exceed inflation. Don’t jump into an overhaul of your portfolio because of the fear of long-term high inflation. As Jason Zweig of the WSJ says, “Fear is a good investing philosophy only for the people who sell it.” You may already be protected.
Conclusion: The key is to focus on real returns and stay invested in a diversified portfolio with an asset allocation consistent with your risk profile. If you’re not sure, give us at DWM a call or email us. We’d be happy to review with you how well protected you are and what your likely real returns might be in the future.