There has been lots of talk about inflation recently, so we wanted to share our thoughts. Simply put, inflation is the increase in the prices of goods and services over time. However, let's take a step back and discuss the role of the Federal Reserve (Fed). The Fed has two mandates; maximize employment and price stability. The price stability mandate was designed so consumers do not have to worry about wild fluctuations in the prices of goods and services. The Fed has concluded that a 2% target for inflation is most consistent with this mandate, meaning they would like to see prices rise 2% annually while tracking a basket of goods and services. You can also look at this as the value of your unspent dollar declines by 2% every year. A good visualization of inflation is when you compare prices for goods and services in the 1950s, 60s, and 70s to today.
Since the financial crisis, the Federal Reserve has generally not achieved its 2% inflation target. This is partially due to the natural deflationary nature of technology and its growing role in our economy. Simply put, the ubiquitous flat-screen television that costs $150 today used to cost $1000 ten years ago. While the prices of things like healthcare, housing, and education have been indisputably rising, this has been counterbalanced by the deflationary forces of technology.
What is different today versus the prior decade is our global response to COVID-19 has created an inflationary environment we have not seen since the 1970s. Shutting down and restarting the global economy has created significant supply chain issues, causing price increases of goods in many industries. In the US, paying people to stay home has created labor shortages that have stoked significant wage inflation. By official figures, we are currently experiencing inflation in the mid-to-high single-digit percent. There are reasons why some of this inflation is transitory, i.e., when the supply chain issues resolve, prices should come down (think used car prices). However, there are some areas where this is not likely, for one, wages. Companies that were forced to increase what they pay their workers are unlikely to lower their pay in the future.
What concerns us is if this elevated level of inflation persists for a more extended period than we currently expect, we believe it could be very negative for fixed-income assets. Generally speaking, a little bit of inflation does not significantly affect the prices of stocks and bonds. However, the current environment is defined by very low relative interest rates (another response to COVID-19) and high inflation levels.
Fixed-income assets provide yield, that is, the interest rate divided by the price of the bond. If the inflation rate is higher than the yield, your real yield becomes negative, meaning you lose money holding this security. Since this is uneconomic, it creates a natural outflow from fixed-income assets and puts pressure on prices. Given that fixed-income asset prices and yields move opposite to each other, lower bond prices mean higher yields. This makes common sense since you need higher yields to compensate you for the higher level of inflation.
As discussed in our Active vs. Passive Debate Perspective, most money management available to individuals today is based on the Modern Portfolio Theory. This means a portfolio is composed of some combination of stocks and bonds, often referred to as 60/40 (60% stocks and 40% bonds). Stocks are in the portfolio to appreciate in value, while bonds provide stability and a source of interest income. But if inflation puts pressure on the bond side of your portfolio, you risk losing money, something that historically was not expected. Additionally, a second-order effect of rising yields is pressure on stock valuation multiples.
We are not in the business of making big calls, but we are in the business of being prepared for the probability of various outcomes. This is why we own very little traditional fixed-income, preferring less interest-rate-sensitive credit and allocating to assets less correlated to financial markets that should benefit from inflation.