A Super Genius Weighs In On Inflation
I have a friend, a hedge fund manager of course, who was filling out a job application years ago at a major Wall Street asset manager. In the section asking about special skills and abilities, he wrote “Super Genius.” I can’t remember if he got this particular job—it’s possible that he did—but I have often giggled about the look on the human resource manager’s face upon reading his application.
Now, this fellow is extremely smart, and he is also clearly not lacking in the chutzpah department. I’m not sure I would categorize him as Super Genius though. Seems a bit inflated, which brings us to a topic on the minds of not just many investors but also business owners and grocery shoppers. Inflation. Is. Here.
I’m old enough, just barely, to remember the inflation of the 1970s and the terrible impact it had on this country. Rooted at least in part in America’s departure from the gold standard and exacerbated by energy crises, inflation reached 14.5 percent by 1980, helped chase a U.S. president out of office and came to symbolize a general sense of economic malaise and even societal decay that persisted until the Volcker Fed brought it under control with higher interest rates and slower reserve growth.
According to the Labor Department, consumer prices rose 5 percent last month, the largest increase since August 2008. The 3.8 percent increase in the core number, which excludes the volatile categories of food and energy, was the largest increase since June 1992. That’s when I graduated from college. For perspective, I have a child who graduated from high school last month.
There’s no disputing these are historic increases. But before we race to the gas station and get in line, let’s take a deep breath. One reason these increases are so large is that last year prices were so depressed. Governments around the world were doing everything they could to keep prices from collapsing. So the denominator (pandemic-pressured prices last year) is juicing these price increases.
Even so, it seems fairly obvious that the economy is far, far healthier than anyone could have believed just a few months ago. Pent-up demand is meeting supply that has been constrained by supply chain problems and labor shortages, so it’s only natural that prices are rising, and it is possible, depending on what happens with consumer expectations, that some inflation continues. As Nobel laureate Gene Fama recently pointed out, the longer inflation or deflation persists, the more likely it is to persist.
Still, there is a component to these price increases that seems decidedly short-term. Generous unemployment benefits are keeping some service workers on the sidelines, but those benefits will run out by the end of the summer and in many states well before, and this ought to ease the labor crunch in the service sector. The microchip shortages that have created a frenzy in the used car market, driving prices up more than 7 percent last month and accounting for about a third of the entire increase in overall prices, will eventually be met with new supply. Globalization has been a crushing weight on inflation for decades, and the base case is that this will continue to suppress price increases.
That’s the company line at the Federal Reserve anyhow, and it’s important to remember that this is actually what Fed Chairman Jay Powell explicitly predicted last September. At that point, the central bank was still so concerned about falling prices that it indicated it would allow the economy to run a little hot instead of pre-emptively raising interest rates. Of course, at that point, there was no such thing as a COVID-19 vaccine. Fast forward to today and we have a $1.9 trillion stimulus package coursing through our veins, potentially another $2 trillion in infrastructure spending on the way, and COVID-19 is on the run. (I actually went to a party last weekend! With people!) Also, I think it’s worth noting that the globalization bandwagon has gotten a little less crowded in recent years as populist and trade protectionist forces have gathered momentum. Combined with an aging population in rich countries and in China, the relative strength of deflationary forces is strong, but not as strong as it was just a few years ago.
So far, the financial markets have taken the whiff of inflation in stride. The threat of higher rates has taken some steam out of the more speculative sectors of the market such as growth stocks and long-dated fixed income, but other areas, such as financials, commodities, and value stocks, have done extraordinarily well. Inflation is a serious threat, but it is only one factor of many that the markets are always in the process of discounting. That’s why good old-fashioned diversification is so important.
My friend might think he is a super genius, but for the rest of us mere mortals, diversification and commitment to a plan still seem to work well. How long will inflation last? No one knows for certain, and there are reasons to be watchful, but diversification and a tilt toward value has historically served investors well over time. The real genius is in mastering one’s emotions, not mastering the market.
Burke Koonce recently joined Trust Company as the firm’s Investment Strategist, working out of our Raleigh office.