Time to Read: 8 Minutes
As discussed in our last webinar, we believe the recovery from the COVID-related recession continues to take hold, partially driven by the massive amount of monetary and fiscal support provided in 2020. Clients of BWM have begun asking: Will all that money printing lead to an inflation problem in 2021? While we never like to predict outcomes, we believe price pressures will indeed firm in 2021. Ned Davis Research (NDR) expects the Consumer Price Index (CPI) to reach 2.2% by year-end 2021, above the 1.4% level seen at year-end 2020. Below, we explore the current inflation environment as well as our prevailing forecast and portfolio implications.
What is inflation, and is it always bad?
Inflation is the decline of purchasing power of a given currency over time. This is generally reflected by an increase of an average price level of a basket of goods and services in an economy over a stated period. In the U.S., the most commonly used inflation measure is the CPI. Since food and energy costs are more volatile than the rest of the basket, the CPI is usually shown alongside an additional metric known as core inflation, which is the CPI less food and energy.
Inflation is often contrasted with deflation, which is when the purchasing power of money increases and prices decline. Deflation may not seem to be a bad thing, but it usually causes massive economic decline as companies and individuals stop spending and wait for prices to continue to decline. This causes a negative feedback loop where the economy can continue to decelerate until inflation kicks back in. Two periods of historical deflation are the Great Depression of the 1930s and the Great Recession of 2008-2009. For this reason, our central bank (the Federal Reserve) has targeted a modest level of inflation in its policy goals.
If inflation gets too high, there can be major costs for an economy. Businesses and consumers must account for the rising prices in their buying, selling, and planning decisions, which introduces an additional level of uncertainty into an economy. In BWM’s world of financial planning, higher inflation means clients face higher expected costs in the future, which may result in clients being unable to achieve their goals without significant modifications to their plans.
In sum, some inflation is good—but too much is bad.
Where is inflation today?
Today, there are powerful structural forces exerting both inflationary and disinflationary pressures on the economy. On one hand, inflationary forces include the reverse globalization trends that have emerged in the past several years, massive government budget deficits and debt, and a likely precautionary inventory build. On the other hand, aging demographics, ubiquitous technology in all things related to production and communication, still-high levels of global integration, and a large private sector debt load are disinflationary. According to NDR, the simultaneous push and pull on inflation from these forces suggests that longer-term price trends should remain contained.
At BWM, we believe the economy is still in a reflationary period that began with the recovery of the COVID-induced recession of 2020. The latest recession was unusual in that the virtual shutdown of the economy in spring 2020 exacerbated the depth of the contraction, making it the steepest on record. The reopening of the economy, however, was backed by massive stimulus, ensuring that the recession was also the shortest on record. The large swing in aggregate demand first depressed consumer prices but later caused a reversal, with pockets of price pressures emerging, particularly in commodities, as shown below.
We would be remiss if we did not mention that there are some signs inflation could become a longer-term worry if left unchecked. First is the sheer amount of monetary stimulus injected into the economy. The chart below shows the record year-over-year change in U.S. money supply.
As more money is “printed,” the value of the U.S. dollar could continue to decline, therefore reducing the purchasing power of the dollar over time (i.e., inflation). We don’t think it is a problem yet: While the dollar has declined over the past year against many major currencies, it remains within a longer-term trading range, as shown by the orange line chart below. The current decline might be inflationary in the short term, but the CPI is still below 2% on a year-over-year basis.
Taking action: Our forecast and portfolio implications
Inflation has been well anchored in the U.S. since the 1980s and there is no reason to expect the type of runaway inflation seen in the 1970s anytime soon. Looking ahead, we believe moderate upward price pressure will continue if the economy continues to expand and monetary policy remains accommodative. This scenario would likely be supportive for equities, real estate, and other real assets like commodities. It would be a headwind for bonds as rates rise from exceptionally low levels and cash—which pays next to nothing—would lose purchasing power. Bonds and cash, however, are very useful in market declines and deflationary scenarios, which cannot be ruled out.
At BWM, we increased equity benchmarks in most models and shortened the duration of our portfolios earlier this year in light of our forecast. In addition, we plan on introducing a new model “sleeve” later in Q1 2021 that should feature more inflation-protected assets, such as commodities and real assets. In the meantime, we will continue to monitor our objective indicators for any sign of a serious inflation threat.
Investment advice offered through Stratos Wealth Partners, Ltd, a registered investment advisor; DBA BWM Financial. Stratos Wealth Partners and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only; and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.