Many people alive today do not know what it is like to live through inflation of any significance. The last time the United States experienced inflation on a major scale was in the 1970’s. Recently, the Great Recession brought on deflationary pressures. Those pressures have started to subside, while inflationary pressures are on the rise. Here are a few of the major inflationary pressures we see today:
- Baby boomers retiring: An estimated 10,000 people a day are signing up for Social Security and Medicare. We still have 12+ years until the last of the Baby Boomers retire. Likely, our $20 trillion debt will only be increasing in the years ahead.
- Trump’s America First agenda: Part of the reason inflation has been benign since the 70’s is the growth of global trade. Americans have been able to buy cheap goods from overseas. Trump wants to increase our exports. That means a lower US dollar versus other currencies and higher prices for goods.
- Central Banks debasing the value of money: German, Italian and Spanish two-year bonds have negative interest rates. The impact of negative interest rates means you pay the lender for the pleasure of owning their bonds. In the United States, Janet Yellen told us years ago that full employment was 6% and, at that time, interest rates should be normal. We reached that 6% threshold in September of 2014! Today, unemployment is 4.4% and short-term interest rates, according to the Taylor rule, should be above 3½%. The Federal Reserve (the “Fed”) is way behind the curve in raising interest rates.
- Employee cost pressures: Feedback from our small business owner clients have highlighted the fact that employers are paying higher wages to employees. As the workforce pool narrows, wage pressures increase. Wages, on average, represent more than 60% of the cost of an item. Higher labor costs = higher inflation.
The problem with cost push inflation is that the trend starts out gradually and then spikes quickly if the Fed is too slow in its attempts to control inflation. Will we see this effect in a month, three months or a year? Nobody knows. Inflation is like a pressure cooker that will explode if the pressure is not released (i.e., raising interest rates before inflation gets out of control). The last time the Fed was behind the curve was in the mid-70’s. That is why it had to take dramatic measures (mortgage rates above 20%) in the early 80’s to quash inflation. We don’t believe future inflation pressure will be as bad as the 70’s, but the longer the Fed takes to normalize interest rates, the higher it will have to raise them to control inflation.
The best way to protect the value of a portfolio against inflation is to have a portion of the portfolio invested in “real assets”. When you have an inflationary environment, real assets (commodities, precious metals, real estate, etc.) tend to perform well while financial assets tend to do poorly. Below is a chart showing how real assets have performed relative to financial assets dating back to 1925. During the inflationary times of the 40’s and 70’s, real assets performed much better than financial assets. In today’s environment, real assets are the cheapest they have ever been compared to financial assets. Given this, it is our opinion that investors should get “real” with a portion of their investment portfolio.