In November 2021, the year-over-year inflation rate hit 6.8%, the highest level in 40 years. For context, the long-run historical average is 2%–3%. Investors are rightfully concerned as high inflation has historically been bad for both bonds and stocks. It hits our buying power as consumers as well. At Hesperian Wealth, we call inflation one of investing’s two biggest risks for good reason. But is the inflation we’re experiencing a temporary spike related to the pandemic or the beginning of a full-blown inflationary spiral? As we discuss in this article, our framework for assessing inflation risk keeps us on red alert.
The Cause of Recent Inflation
The refrain from many investment strategists has been that the recent high inflation readings have been a temporary consequence of the pandemic that would dissipate by the fall of 2021. But this didn’t happen. On the contrary, inflation has accelerated into the winter months.
No doubt, the pandemic spurred inflation. Prices collapsed briefly during the lockdowns of March and April 2020. So some of the price inflation that showed up early in 2021 was just a rebound from that year-ago period.
In addition, consumer behavior changed a lot in the early part of the pandemic. People bought unusually more “stuff” and spent less on “experiences” or services because of the COVID risk. All the stimulus payments supercharged this spending—personal incomes actually went up. But the manufacturing world wasn’t ready to make all that stuff. So demand shot up and supply couldn’t meet it. My brother bought some furniture, for example, and he waited over a year to get most of it and is still waiting on a few pieces. You’ve probably seen in the news about all the container ships circling off Pacific ports because there’s such a backup getting them unloaded. Have you tried to buy a car lately or sell your own? You’ve either been hit hard by that or else made out like a bandit. Auto manufacturers can’t get enough computer chips, so cars and trucks are in short supply.
Inflation Risk Going Forward
At Hesperian, we seek to be systematic and data-centric. We don’t make predictions, we assess probabilities. In that effort, we first look for reliable indicators. For inflation to be a problem for us as investors, it would have to continue to accelerate. It turns out, one of the best indicators of future inflation has been … past inflation. That’s because a big component of inflation is psychological. As inflation increases and people start to realize that the prices of goods and services will be higher tomorrow than they are today, they’ll pull forward their purchases. As more and more people do this, the abnormally high near-term demand causes prices to rise further, leading more people to spend now versus saving and so on. That’s how a spiral can take off.
Historically, once inflation is 5%-plus and higher than it was six months ago, watch out! Shortly after almost every time this occurred since 1960, either inflation ended quickly due to a recession or inflation continued to rise out of control (eventually also leading to a recession). None of these events were kind to bonds or stocks.
The chart below shows the annual inflation rate (the black line), when our simple indicator described above signaled inflation risk was high (the red areas), and official US recession periods (denoted in grey).1
Hopefully, you can see why this is a valuable dashboard for us. Bad things often happen when our risk indicator is flashing red. Of concern: Since August of last year, inflation has been 5% or greater and rising.
The Cases for Inflation Receding and Accelerating
Now with Omicron, people may pull back from spending and inflationary pressures may be offset. However, we don’t think you’re going to get people to accept lockdowns as they did in 2020. Not with vaccines and boosters and better treatments. Thus, any economic disruption will likely be much, much less severe without a more dangerous variant emerging.
Another reason to be optimistic about inflation is that markets seem to be convinced that it will eventually moderate naturally. Measures of inflation expectations still suggest longer-term inflation will be quite well behaved (see the chart below).
That said, the market could be wrong. There has often been a big gap between the inflation rate the market expected and the inflation rate that actually happened (the gap between black and red lines on that last chart). We’re skeptical the market would sniff out a shift to an inflationary era after so many decades of normalcy.
Instead, we think inflation could stay high over the next year and beyond. In the very near term, rising shelter (rent, housing) costs look set to take over where pandemic-related price increases leave off. Typically, shelter costs rise after home prices rise with a lag. And home prices have jumped a lot; almost 20% year over year based on recent numbers. Since shelter makes up about a third of the Consumer Price Index, or CPI (the headline inflation number you often see quoted), it will probably keep inflation high for the next year.
Longer term, we think the pandemic may have accelerated a big turning point in the economics of the world that was destined to happen anyway. Globalization was already retreating. Given the adversarial relationship between the US and China, manufacturing has been returning to North America. COVID simply accelerated this. It didn’t feel good to be reliant on production in Asia for ventilators and masks during the pandemic. On the positive side, onshoring provides more jobs domestically, increases workers’ share of the economic pie, and secures our access to goods. On the negative side, it leads to higher prices because both labor costs and plant construction costs are higher here than in less-developed countries.
We are also strong believers in demographic analysis and group psychology. Peter Zeihan2, a geopolitical consultant we follow who specializes in demography, posted a couple of videos here and here around the holidays that provide a really good introduction to his analysis.
He argues that the demographics of our country (and other countries for that matter) combined with generational differences have led to and will exacerbate a labor shortage. This means higher prices and higher inflation for years to come. He may be wrong about his generalizations about different generations’ work styles and desires, but the demographic data is undeniable. For the foreseeable future, there will be fewer and fewer workers to power our economy, keep labor prices down, and pay into social security schemes that support the retired.
Confirming this, we have elsewhere seen countless stories about a lack of truck drivers, a lack of welders, millions of open yet unfilled job positions, mass early retirement, and on and on. It’s not just restaurant and retail workers that are quitting. This is putting upward pressure on wages, which is exactly what well-known Yale sociologist and physician Nicholas Christakis finds happens after pandemics.3 And rising wages are linked with inflationary episodes. You can take comfort in the fact that the situation in the US from a demographic perspective is relatively better compared to most of the world (except for Africa). But the next couple of decades is still likely to be an unusual time for anyone who has experienced only benign inflation during their lifetime.
All these economic and labor market changes, if they come to pass, would cause many long-term trends to reverse. We won’t get into the details here, but suffice it to say, the portfolio implications are radical. The investments most likely to be successful in such a new world are not the same ones that did well the last 10 or 20 years (hint, hint: not traditional stocks and bonds).
Hesperian’s Charge
As stewards of clients’ savings, we intend to navigate their portfolios through any potential return to inflationary times. How? In our next post on inflation, we’ll walk through all the arrows in our quiver when it comes to seeking protection against rising prices. There are a lot of myths out there about inflation hedges, even among professionals. We’ll wade through them and let you know which are fact and which are fiction. Until then, take care, and happy New Year!
Eric R. Figueroa, CFP®
I am a Folsom, CA, fee-only wealth manager serving the Greater Sacramento area, California Gold Country, and the nation virtually. I offer financial planning and investment management, specializing in impact investing and personalized values-based investing.
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1 Importantly, inflation data unadjusted for seasonal effects are not susceptible to revision, and we lag our indicator by two months to address look-ahead bias. To understand why, consider that we’re writing this in early January 2021. We don’t yet have December inflation rate data, which comes out later in the month. So at the beginning of January, we could only make investment decisions based on the November inflation data available to us at the time.
2 Zeihan was a former analyst at Stratfor, a well-known Austin-based geopolitical consulting firm. He is the author of several books, most recently Disunited Nations, all of which we highly recommend if you have an interest in demography, geography, and geopolitics. He has a great online newsletter too where he posts regular articles and videos free to the public. We have no affiliation with him or his firm.
3 Recent interview on Amanpour & Co.; his recent book Apollo’s Arrow.