The economy is strong, certainly stronger than anyone would have predicted from the depths of the Covid recession last year, and the question on everyone’s mind seems to be whether it can continue to grow or is a recession on the horizon. We don’t think that is the right question. The better question is what could jeopardize the strength of the ongoing recovery.
We’ll first point below to two charts, compliments of our friend Scott Grannis, which show the current strength of the economy.
Both demonstrate that whether you measure U.S. net worth on a national level (left chart) or on a per capita level (right chart), we are as rich, if not richer, than ever before. The U.S. economy’s net worth is slightly more than $130 trillion, representing a solid 10% growth from last year (before the covid shutdown). Total household net worth is right on track with a 3.6% long-term annual trend rate, and per capita net worth is slightly above its 2.3% per year long-term trend rate.
Further evidence was presented by the Federal Reserve at its most recent meeting when they raised their real GDP growth forecast for 2021 to 6.5%. Along with that, they projected drops in unemployment to 4.5% at the end of 2021, then 3.9% at the end of 2022, and ultimately 3.5% in 2023. We could also point to other supporting data such as airline travel, corporate profits, and annual durable goods order.
The point should be clear; the economy is not declining, nor even teetering. It is growing steadily, and there is nothing about the growth which implies that it is artificial or in a bubble. The prospects for the future are very strong, and the primary risk – aside from an excessive increase in the tax and regulatory burden – is inflation and the steps which might be needed to combat that inflation.
What Causes Inflation
Inflation is, and always will be, a monetary phenomenon. It is defined as a general rise in prices. If the price of one product goes up, while others stay the same or while others decrease, that is not inflation. If all prices are trending upward, that is inflation. We all pay for the stuff we use and buy with money. When the government prints more money, we use that extra money to try to buy more stuff. But since everyone is trying to buy more stuff, the extra money simply increases prices.
The general measure of the supply of money is something called “M2”, and it has never grown as fast as it has over the last year – roughly 25% more money today than a year ago. The reason we haven’t seen a corresponding 25% increase in prices is because thus far, people have wanted to save their money more than spend their money.
In the illustration above, we mentioned that when people use the extra money to buy more stuff, it pushes prices up (inflation). But what if people don’t use that money? What if they just stick it in the banks? In that case, the money wouldn’t be used to push up prices. That is exactly what Covid has done.
People’s concern and fear about the future has prompted them to stick the extra money into their bank accounts. There will come a time when the fear eases, people’s desire to keep cash decreases, and their desire to spend it increases. That is when inflation will hit, and it will hit to the degree that the Federal Reserve cannot effectively withdraw the extra money they have created.
The Effects of Inflation
We already see some signs of that, but fortunately, at manageable levels. As of this writing, inflation, as measured by the CPI, is about 1.8% on an annual basis. The Fed says they expect it to go to 2.4%, but we’re already seeing producer prices climb 2.8%, and we believe that we’ll see inflation hit 3% to 3.5% this year.
There are several major problems with inflation. Interest rates rise; prices rise, but not evenly, artificially creating winners and losers in the economy; and it distorts decision making because it is an extra unknown that consumers and managers have to deal with. The greater and the more unexpected the inflation, the worse the results, as demonstrated by the following table.
Inflation’s effects on the actual components of an investment portfolio are still different. Inflation will affect stocks differently than bonds, and even within those categories, the effects will vary. Adjusting a portfolio for inflation is a complicated matter – one best left to professional managers – but let’s try to unpack it a bit.
Inflation’s Impact on Stocks
A stock’s price represents the present value of that company’s future profits, and profits are simply revenue minus costs. If a company can immediately react to an increase in its costs by raising its prices to its customers, the company’s profit margin will remain. If the company has long delays in making that adjustment, then profits get squeezed in the short term, and the stock’s price goes down.
Think in terms of a soap manufacturer vs. an airplane manufacturer. The soap manufacturer should be more easily able to increase prices as costs rise. The airplane manufacturer typically commits to delivery contracts at set prices over a longer lead time. One estimate put the lead time from 12 to 36 months. That’s a significant amount of time until prices on new plane orders can be adjusted to reflect cost increases, so profit margins get squeezed.
While there are significant moderating and hedging techniques company managers can use, the basic principle illustrates the difference in inflation’s effect across industries. The strength of each individual company’s management is also an issue. Stronger managers will be better than weak managers at forecasting and protecting against inflation regardless of the industry.
Inflation’s Impact on Bonds
Bonds, on the other hand, are impacted by inflation in a different way. The basic bond structure represents a company (or government) borrowing from someone at a set interest rate. A bond is a loan from you, the investor, to the company or government which issues the bond. As interest rates rise, the value of old bonds is hurt because the old rates are too low. The longer the bond has until it matures, and the borrowed money is paid back, the more severe the decrease in the bond price.
Here again, there are moderating techniques such as floating rates, step-up rates, and collateralizations, just to name a few. Additionally, the health of the company which issued the bond and borrowed the money is relevant. If inflation is hurting a particular company severely, the security of that company’s bonds might be questioned, and the price of that company’s bonds hurt accordingly.
Not As Simple As Stocks Vs. Bonds
Over the long-term, it is safe to say that stocks will perform better than bonds, and in the short term that short-term bonds will perform better than long-term bonds. On that basis, we could make a strong case to shift portfolios from bonds toward stocks, anticipating the elevated inflation levels we project.
But we all live, and often react, in the short-term. We all rely on our portfolios to achieve a goal, whether it is to hit a specific value needed for retirement or to fund a stream of withdrawals during retirement. How the portfolio performs during the short-term can be as important to someone as to how it will ultimately perform over the longer-term. So, inflation in the short-term matters in terms of how we structure the portfolio.
The Value of Professional Help
As should be obvious by now, there are so many variables at work (stocks vs. bonds, industry selection, management strength, length of bond, type of bond) that this begins to look like complicated surgery. And that’s a great analogy to use.
Common sense tells us all to go to a medical specialist when we have a serious issue; orthopedics for the spine and cardiologists for the heart. Each doctor is a professional, which is what we need, but each is a specialist, which is also what we need. The same is true in the investment world. Serious portfolios need professional management, and those managers need to be specialists.
As we at First Financial structure and oversee portfolios, we use specialist professional money managers in each key area (large growth stocks vs. small-cap stocks vs short-term bonds, etc.). As we move into a new inflationary era, we evaluate these mutual fund managers to make sure that they are taking the proper steps inside their funds to mitigate the risk inflation represents in the short-term while preserving the upside in the long-term.
We wish this was as simple as some web and media commentators claim; we wish it was as simple as saying “avoid bonds and buy stocks.” But it’s not; the details are too important to be ignored, and we’re committed to helping clients make any necessary fine-tuning adjustments to ensure that long-term performance goals are ultimately met and that near-term liquidity and stability goals are also met.
We are not predicting a return to the high inflation and stagnation years of the late 1970s, nor are we predicting that interest rates will remain at historically low levels. We are predicting a bit of inflation on the horizon, and we are committing to helping clients through this period as we do in all the economic storms we face.