Recently there’s been a lot of discussion about inflation. How is it impacting the economy? How is it impacting my investments? What adjustments can we make so that we’re better prepared to deal with rising interest rates? These are complex questions that often require a long-term approach to provide context and find a solution.
Let’s first clearly define what inflation is. At its core, inflation measures the change in prices. A commonly quoted index is the CPI (Consumer Price Index) which measures the average change in price for a market basket of consumer goods and services.[1] At the end of March, the year over year increase in the CPI was 8.5%.[2] Some of the most obvious places we notice inflation is at the gas station or the grocery store. Rising costs put pressure on consumers and businesses, often times leading to less spending, lower profits and increased borrowing costs (e.g. mortgage rates increasing). Historically inflation has averaged 3.26%[3]. In addition, it is a metric which tends to revert to the mean. Less than 3 years ago we were in a persistently low inflation environment. Now it is just the opposite. Our view is that over time inflation will revert to its long-term average. While inflation is uncomfortable in the short term, it is an ordinary part of a healthy business cycle.
The idea that high inflation is bad for investing, particularly fixed income investing, is widely misunderstood. The fear is that high inflation will cause the Federal Reserve to increase interest rates. When interest rates increase, existing bond prices drop and the value of future earnings decrease. While this theoretically is the case, we think looking at historical data can help shed some light on past interest rate hikes. Below is a chart outlining the performance of the Dow Jones Industrial Average, S&P 500 and the Nasdaq composite during previous periods of rate hikes.[4]
As one can see from the chart above, all three indexes had positive average gains throughout their respective periods of rate hikes. While history is no indication of future performance, I think it provides good context to the current inflation narrative.
There are many steps a person can take to prepare for inflation. There are investments which inherently adjust and change with inflation (e.g. TIPs, floating rate bonds). However, one of the most prudent steps is reviewing one’s financial plan and making the necessary adjustments. Inflation can meaningfully impact cash flow projections, so understanding the inflation assumptions in your financial plan is important.
Big picture, the inflation narrative is dominating current news, and the feds response to inflation is uncertain. Overtime inflation should revert to its mean level. In addition, high inflation and rising interest rates aren’t necessarily bad for investment outcomes (the data would show otherwise). We encourage you to review your financial plan and the inflation assumptions in it. We’re here to help.
-The AdvisoryOne Group
The opinions voiced in this material are for general information purposes only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
[1] Consumer Price Index. U.S. Bureau of Labor Statistics.https://www.bls.gov/cpi/ (Accessed April 22, 2022).
[2] Ibid.
[3] United State Inflation Rates. Trading Economics. https://tradingeconomics.com/ (Accessed April 22, 2022).
[4] How Does the Stock Market Perform When Interest Rates Rise. Forbes Advisor.https://www.forbes.com/advisor/investing/how-interest-rates-affect-stock-market/ (Accessed April 24, 2022).