The scary inflation headlines are all around us and they are getting worse with the horrific news in Ukraine. Compared to a year ago, general prices have risen around 6% to 7%, well above the usual 1.5% to 2% inflation we’ve enjoyed for a long time. Obviously, the recent spike in prices comes as quite a shock. For those with longer memories, the recent headlines feel eerily reminiscent of the runaway inflation of the ‘70s.
Without full confidence, and like the Fed itself, I cannot set aside my belief that the primary driver of our current inflation surge is the pandemic and our reaction to it. We did the only things we could. The Federal government borrowed heavily to smooth out the economic pain and the Fed cut interest rates to zero and bought more assets. The policy choices were few and far between.
Prior to the pandemic, our global economy was basically traveling at high-speeds, bumper-to-bumper and on cruise-control. When Covid ran across the road, the economic pile-up was downright ugly. The economy’s subsequent “re-opening” has acted like the uncoiling of a tightly-wound spring of pent-up demand. This surge in demand has been met with a still-constrained supply of goods and services. This imbalance is both painful and temporary, in my view.
When I dig into the inflation data, I do see reason for hope. For starters, the price spikes of certain items are punching way above their weight class. Is it reasonable to assume the 40% year-over-year spike in both used cars and gas prices and the 12% year-over-year pop in new car prices will be repeated in the future? Together, they explain almost 50% of the inflation we’re seeing today, but they only account for about 12% of our spending. When these extremes naturally moderate, so too should our inflation headlines.
The ghosts of the ‘70s are now appearing in the minds of the Fed and politicians. They know that once a self-reinforcing cycle of price hikes followed by rising wages gets going, it can be very painful to stop. Their prescription includes a combination of interest rate hikes, the end of asset purchases and, ultimately, the shrinking of their balance sheet. For added insurance, they are also signaling that they aren’t afraid to push us into a recession, if that’s what it takes.
There is evidence that the Fed’s commitment to stopping inflation is believed by investors. For example, market-based inflation expectations are not wildly rising. Expectations of annual inflation five years from now sits at about 2.4% as compared to about 1.7% just before Covid hit. Looking over the past decade or so, today’s views about future inflation aren’t all that different than before. While the Fed does have reason for concern, panic is not yet in the cards.
Investing in the face of these uncertainties is obviously a serious challenge. I’d first caution against the abandonment of bonds, regardless of recent negative returns. I’d also caution against the allure of rising commodities. Swinging at pitches after they’ve landed in the catcher’s mitt is not a recipe for success. I know I sound old, but please forget about cryptocurrencies, too.
Without trying to sound overly passive, it’s always wise to stick to the tried-and-true advice of maintaining a reasonable mix of stocks and bonds. Beyond that, I’d note that after the rise in interest rates over the last six months, shorter-term bonds are looking much more attractive than before. And, of course, it’s always a good bet to stick with solid companies that have the ability to somewhat deal with the challenges of inflation while continuing to pay out reasonable dividends.
While today’s bold headlines have a way of grabbing our attention – and, yes, uncomfortable inflation can be felt all around us – my humble view is this too shall pass. My sincere hope is that the conundrum of inflation won’t be too painful to squash.