Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.
–Sam Ewing, former professional baseball player and All-American at The University of Tennessee
On Wednesday, November 9, Janet Yellen gave what was most likely her last testimony to the Joint Economic Committee as Chair of the Federal Reserve. In her testimony, she stated that she felt the economic expansion is broad-based and that the economy will continue to expand, thus growing wages and incomes. Yellen said, “We continue to expect that gradual increases in the federal funds rate will be appropriate to sustain a healthy labor market and stabilize inflation around (our) two percent objective.”
So why does the Federal Reserve try to manufacture and sustain a 2% inflation rate? At a 2% inflation rate, $50,000 worth of purchasing power today will buy only $30,173 worth of goods in 25 years. Does not inflation, a general rise in the price of goods and services, put a drag on the economy? Well, no, not exactly.
Though conventional wisdom contends that inflation is bad for the economy, inflation at a low, sustainable, and predictable level allows both consumers and producers to confidently make informed decisions that lead to greater growth in the economy.
As we mentioned earlier, long-term inflation has the negative effect of reducing purchasing power. Furthermore, unforeseen high inflation causes extreme volatility in the stock and bond markets. Interest payments from fixed-income instruments are devalued and some sectors of the economy see higher raw material costs and, thus, smaller profit margins.
On the other hand, low, predictable inflation has several positive effects. The prices of homes, precious metals, stocks, bonds, and other assets trend upward and, thus, have a wealth-building effect for owners of those assets. Inflation also makes it easier for those who borrow long-term, as these debtors will pay back their loans with future dollars that have less purchasing power than today. A 30-year mortgage payment of $2,000 today will still be $2,000 in 20 years, but will be worth only $1,087 with 3% inflation. This encourages both leading and borrowing.
Famous British economist John Maynard Keynes postulated another positive benefit for the economy with low inflation and called it the “Paradox of Thrift.” Keynes felt low inflation was necessary for the economy in order to spur growth. Otherwise, if consumer prices are allowed to fall consistently, consumers would tend to hold off making purchases and wait for a better deal, thus stalling economic growth.
Portfolio Construction
Given that the Federal Reserve is seeking a 2% annual inflation rate, how does that effect your portfolio allocation? In other words, how do we mitigate inflation risk which, as we explained, has a long-term devastating effect on your portfolio’s purchasing power? Inflation risk is a major concern for a retiree. Recent retirees, after having worked 40+ years and receiving a paycheck based on their human capital value and probably matching or, perhaps, exceeding inflation, suddenly are looking at 25+ plus years in retirement without steady paychecks. Even with social security benefits that include annual cost-of-living adjustments and, perhaps, a non-inflation adjusted pension, portfolio growth and income will probably fund well over half of the retiree’s retirement cash flow needs.
That is why we always emphasize keeping a long-term view of the markets while intellectually discounting the effects of daily volatility. In the short-term, there is no asset that is a perfect inflation hedge. However, over the long-term, stocks play a critical role. On a daily basis, stocks are quite volatile, but over the long-term, stocks can battle the effects of inflation. Stocks represent large, well-managed companies that are actively responding to their particular market conditions, including the effects of inflation on their operations. A well-diversified portfolio of large and small companies, both U.S.-based and international, can adapt over time to the inflationary environment. For bonds, which tend to fall in price in response to signs of inflation, over-time yields may rise to attractive levels.
Inflation, although not as gut-wrenching as a market crash, can be even more devastating over the long run by steadily eroding the purchasing power of your portfolio year after year. Historically, U.S. stock market crashes have been followed by a recovery, although some recoveries can be long and agonizing. But the steady drip, drip, drip of inflation on purchasing power is permanent. That is why we have discussions with you throughout the year regarding your goals and objectives, portfolio allocation, and the emotional roller-coaster of market volatility. Based upon our discussions, your portfolio is invested in a well-diversified, global allocation suitable to your risk capacity and risk tolerance.
As always, we are honored and humbled that you have given us the opportunity to serve as your financial confidant and advisor. Please reach out to us if you have any questions or if you would like to discuss any other matters. We welcome the opportunity and would be happy to talk with you.
All of us at The Nalls Sherbakoff Group, LLC, wish you and your family the greatest of joy, love, and peace this holiday season and a wonderful and happy new year.
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal, or tax advice. The Nalls Sherbakoff Group, LLC makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of The Nalls Sherbakoff Group, LLC. Past performance does not guarantee future results.