Many people are asking us about the prospect for inflation going forward and how we can protect their account. Stocks are a good place to be in periods of moderate inflation; we definitely would favor stocks over bonds in that environment. If inflation gets too high, it does become a problem for stocks (though it is an even bigger problem for bonds). What is too high? Hard to say exactly, but something around 5% on sustained basis is a reasonable estimate. In a higher inflation environment, stock market leadership would narrow to commodity producers. Our process would pick up on that, and we would tilt the portfolio accordingly. We have done so already somewhat as we have bought stocks in the energy and materials sectors this year. We will buy additional similar companies if necessary.
There are several items to keep in mind regarding recent inflation reports. First of all, year over year comparisons are skewed based on last year’s shut down economy; it is natural that inflation is much higher today. Year over year inflation at this point last year, skewed downwards due to economic shut downs, was 0.3%. That’s 2.25% on an annual basis over the past 2 years. Inflation in that range is indicative of a strong economy, which is a positive for stocks.
Secondly, it is important to understand the cause of inflation today. 1.) There is extra demand for many goods and services. Some of it is pent-up demand, and some is due to stimulus. 2.) There is inflation on the cost side as supply chains are disrupted, and the cost of delivering many goods and services has increased (think about the cost of various health/safety measures business must adhere to) 3.) Commodity prices are spiking, pushing up the cost of many raw materials. 4.) The Fed is explicitly aiming for inflation above 2%. Three of these four reasons will expire over the next year or so. Stimulus will wane and demand will normalize. Supply chains will adjust, and health and safety measures will stagnate or recede. New supply will come in to stabilize commodity markets. Inflation is with us in the short term – through the end of the year, and probably a little into 2022 as well. But we don’t see persistent year-over-year increases as these factors wear off.
It is also instructive to think about the forces that kept inflation low for the last 12 years. Aging demographics, advances in technology - particularly price discovery via online shopping, and tighter bank regulations that limited lending were 3 key factors. None of those are being reversed; in fact advancements in technology and changes in consumer behavior over the past year (i.e. online shopping, Zoom, etc) have likely been accelerated. It is our belief that the long-term outlook for inflation has not changed significantly.
The market is currently pricing in inflation averaging 2.68% over the next 5 years, and 2.38% for the 5 years after that. So the market is already pricing in meaningfully higher inflation than what we’ve experienced in the past 12 years. Could inflation be more than 2.68% over the next 5 years? It could, but we don’t think it is very likely. It should continue to be in the short term though.
Bottom line – Stocks are effective inflation hedges in most scenarios, and the character of those stocks can add further protection. There is ample reason to think that inflation should subside as the pandemic-related anomalies wear off. If inflation does prove more persistent, then our process will lead us to own more protection, likely in the form of commodity-related stocks.