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This past year has been a pretty bleak news year. Day after day we’ve all been inundated with scary headlines that basically boiled down to “Are we all going to die horribly today?” Thankfully, those days are starting to recede into the rearview mirror. The world’s biggest vaccination campaign in history is in full swing, California and New York just declared their economies open again, and here in Ontario we can now enjoy a drink on a patio without being tased by the po-po. Progress!
So, in a way, it’s kind of nice to see the news go back to its regularly scheduled programming of dutifully explaining to us why we’re all screwed for reasons other than a deadly virus.
Consumer prices for May accelerated at their fastest pace in nearly 13 years as inflation pressures continued to build in the U.S. economy, the Labor Department reported Thursday.
Consumer prices jump 5% in May, fastest pace since the summer of 2008: CNBC
Statistics Canada said the 3.6-per-cent increase in the consumer price index in May was the largest yearly increase since May 2011.Annual inflation rate climbs to 3.6 per cent in May, highest in a decade: CTV
Hoo mama. Looks like all that money printing central banks did last year is coming home to roost.
Now, just to be clear, inflation is not necessarily a bad thing. To little and the economy seizes up, but too much can cause a recession, and seeing as how we are just getting out of one once-in-a-generation disaster, I don’t think anyone wants to deal with a recession on top of everything right now.
So let’s dive into these headlines and see what’s going on. Why is too-high inflation bad, what’s causing this higher-than-normal inflation that we’re seeing, and most importantly, is it time to panic, bash each other’s heads in and feast on the goo inside?
How Inflation Causes Recessions
Inflation is a broad measure of how much the cost of goods change year over year, and can be tricky to get right. If inflation is too low (or worse, negative), then you get into a situation where people stop spending money. In a deflationary environment, things cost just a little less tomorrow than they do today, so when that happens people hoard cash and delay their purchasing decisions, which leads to a recession because people aren’t spending money and businesses aren’t making a profit. This famously happened recently in Japan over the last few decades.
Hyper-inflation, where inflation is running at greater than 50% per month, is also really bad. In this situation, the price of goods is rising so much that people can’t spend money fast enough, which might seem like a good thing at first but hyper-inflation is also indicative of a complete loss of trust in your country’s currency. Think 1920’s Germany or modern-day Venezuela.
So for that reason, a little bit of inflation is good, but too little or too much hurts the economy. Central banks have a mandate to keep long-term inflation within a target range of 1% to 3%, and have the ability to stimulate or cool down the economy to do it by raising or lowering interest rates.
Here’s the problem: If inflation is too high, it’ll force central banks to raise interest rates. And if that inflation stubbornly refuses to come back down, they’ll have to raise it even more. And if they panic and raise interest rates too much, that might cause a recession.
Remember: Benchmark interest rates affect everything. Savings accounts, bond yields, your mortgage, and corporate debt. All of it goes up when that happens. And while you might be thinking that if your mortgage rate goes up half a percent at renewal, that might not be so bad. But if it goes up a full percentage point? Or five? Bad things will happen.
Hence, the panic that happens on financial markets if central bankers even hint at thinking about thinking about maybe considering raising interest rates sooner than expected. It happened on Friday, when an errant remark from St. Louis Federal Reserve president James Bullard on CNBC sent the Dow plummeting 500 points.
What’s Causing Inflation?
So the big million dollar question is: What’s causing the inflation we’re seeing?
On the surface, the answer would be obvious: All the money central banks printed, all the stimulus that got sent out, and a shuttered economy would naturally produce eye-popping inflation. Printing money and throwing it at a shrinking economy is a classic way to manufacture hyper-inflation, after all.
Here’s the problem: the economy is no longer shuttered. US GDP compared to the beginning of 2019 has basically recovered. Over memorial day weekend, airlines were running at almost 90% of their pre-pandemic levels. The US is not 1920’s Germany, because unlike 1920’s Germany, they just fought a war with COVID, and for all intents and purposes, they won.
What makes current inflation measurements so unclear is that they’re currently clouded by temporary effects that are making them seem worse than they are. For starters, the inflation figures quoted by the media are annual changes, meaning that the baseline they’re comparing to is 12 months ago, when the economy was well and truly shut off.
2020 was a really crazy year. Remember, not only was half the economy prevented from opening, there were crazy things happening on the financial markets that had never happened before. Tourism had been shut off around the globe, rents in downtown cores were cratering due to the AirBnb’s being converted into long term rentals, and for a brief, glorious, extremely confusing day, oil prices turned negative.
So of course if you compare prices to 12 months ago things are going to seem dire. In fact, if you look at the raw CPI price data from the Federal Reserve, you can clearly see that in a May 2021-to-May 2020 comparison, you would be comparing today’s prices to the absolute lowest point on the CPI chart.
If you were to instead compare it to the beginning of the year right before the pandemic hit, you would see that prices are higher, but by only 3.7% rather than 5%. 3.7% is a little hot, but it’s not exactly the panic territory that the media is making it seem.
And the second reason that this number is likely overblown is that there are supply chain issues affecting prices that will eventually go away. Remember, the pandemic caused economic activity to stop in most industries that weren’t deemed essential. Now, all of a sudden, people are being unleashed back into the world with stores suddenly reopening. Retailers can’t keep up with the sudden increased demand for cars, plywood, and refrigerators. So of course prices are going to go up.
But supply chains will adjust, as they always do. Factories will reopen, workers will get rehired, and industrial output will once again spin up. When that happens, supply will rise to meet demand, moderating prices.
How Should We Invest?
Now, all this isn’t to say that the reports of higher than normal inflation is made up. The effect is real, but I’d argue that the effect is far more muted than the numbers would suggest. There are temporary effects that are causing inflation to appear worse than it actually is, but these effects are just that: temporary. We are in an inflationary environment, but I don’t think it’s as bad as these scary headlines make it appear.
So how do we position our investments for an inflationary environment? Well, I think we all know the answer to that: Bitcoin.
No no, I’m kidding. Don’t put all your money into Bitcoin.
The real answer is: Equities.
Specifically, the equities tracked by the very same broad-based index funds that we recommend in our Investment Workshop and we are personally invested in.
In a hyper-inflationary environment where the value of the currency itself is under attack, you want to move your money into an alternative form of wealth, like gold or diamonds. But we are not in a hyper-inflationary environment. We are in a plain old inflationary environment, and in that situation equities will benefit. As the price of goods increases, businesses will be able to charge more. As businesses charge more, they will make more profit. And as they make more profit, their stock prices (and dividends) will increase. Hence, equities is where it’s at in a situation like this.
Fixed income, on the other hand, is another story. In an inflationary, low-interest environment, fixed income is going to suck for a while. Especially since in the event that interest rates rise, those holding longer-duration traditional bonds are going to get screwed since bond prices go in the opposite direction of interest rates.
However, we do have a few tricks up our sleeves. I wrote about them here, so check that article out first. In the interest of full transparency, in our personal portfolio, I’ve moved our Portfolio B fixed income allocation to Preferred Shares (ZPR) and our Portfolio A fixed income to a Short-Duration Bond Index ETF (ZSB). Both asset classes are better in a rising interest rate environment than a traditional bond ETF, and to learn more about why check out the article I mentioned earlier.
So to conclude, so far I don’t think inflation has entered runaway territory, and as a result I don’t think it will derail our economic recovery. That being said, inflation is going to run hot for at least a few months, and an interest rate increase is definitely on the horizon. So we are going to invest accordingly and we think you should too.
What do you think? Do you think all this money printing will screw us all, or do you think everything will be fine? Are you planning on making any changes to your portfolio? Let’s hear it in the comments below!
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