Will inflation return to its pre-pandemic rate or reverse its decades-long decline? And what does this mean for your portfolio?
It’s nearly full circle for those of us who have been following the economy longer than we care to admit. The dominant theme early in my career was the damaging effect of high and rising inflation on stocks, bonds, and other financial assets, all withering under increases in the Consumer Price Index (CPI) peaking in double digits during the early 1980s.
Short-term investments were about the only game in town back then, beyond gold and other tangible, or physical assets. That put the spotlight on money market funds, capable of taking full advantage of then Fed Chairman Volcker’s efforts to break the back of inflation by raising short-term rates to unprecedented levels.
Volcker’s successful effort was the catalyst for a decades-long decline of inflation, or disinflation, propelled increasingly by fundamental changes to the economy. These changes ranged from diminished union power, deregulation, an aging population, and the migration to low-cost suppliers abroad under the banner of globalization. The resulting fall in interest rates accompanying those declines laid the groundwork for the golden era of bonds and stocks, by sending bond prices higher and allowing equities to accommodate higher valuations.
Disinflation’s climax came during the economy’s pandemic-induced freefall, serious enough to trigger declines in the CPI last spring. Inflation still is subdued; however, prices are giving every indication of moving higher. The economy appears poised for powerful growth propelled by the reopening of businesses and by another round of government fiscal stimulus.
Will inflation return to its pre-pandemic rate or reverse its decades-long decline?
What’s next for inflation?
Will inflation return to its pre-pandemic rate or reverse its decades-long decline? Our view is that inflation will face hurdles to building materially on its pre-pandemic peak rate of 2.3%-2.5%. Here’s why:
- By the early part of 2022, economic growth may well throttle back to a more sustainable rate easing demand pressures on capacity as the impact of the economic stimulus subsides.
- The economy’s capacity to produce may be greater than official estimates. Output grew more rapidly than its measured potential for sustained periods during 1996-2000 and again in 2018-2019 without a material acceleration of inflation.
- Those fundamental restraints on inflation that I mentioned previously, though eroding, still appear strong enough to keep a lid on inflation much as they have since the 1980s.
Potential pitfalls and opportunities for investors?
For investors, a moderate rise of inflation does have its potential benefits. The outlook for corporate profits likely may will improve if more rapid price increases are being propelled by economic growth strong enough to lift sales volumes and business pricing power. That same lift to corporate profits can help support credit quality among corporate bond issuers.
Still, be mindful that even a modest rise in inflation and interest rates can have an impact on certain types of securities that happen to be unusually sensitive to interest-rate changes. These securities may include longer-dated bonds and income-generating areas of the stock market such as dividend paying stocks and REITS that may not look as attractive if bond yields start to improve.
Investors looking at their portfolios going forward may want to consider higher quality corporate and preferred securities and those backed by assets, all of which have been less likely to feel the impact of any increase in interest rates. In the stock market, we believe investors should consider the sectors that should benefit from a strengthening economy, such as industrial stocks and materials producers.
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