When inflation surges, pause before hitting the sell button

Inflation has recently reprised its role as a terrifying bogeyman in the financial media. The April Consumer Price Index (CPI) report showed that consumer prices had increased 4.2% percent year-over-year, the highest 12-month increase since 2008 and well above the Federal Reserve’s 2.0% target inflation rate.

But those numbers don’t tell the entire story. We aim to provide some context around the recent inflation data, as well as discuss allocation strategies that advisors may want to consider to combat the potential effects of higher inflation. 

Noise in the numbers

Investors should be wary of high inflation projections on the horizon. Not only is inflation notoriously difficult to predict, the current numbers are potentially biased. The data is presented in a misleading way and includes temporary shocks that will likely subside.

April’s year-over-year inflation number suffers from a distortion called the base effect, where the large 4.2% increase in CPI was the result of an abnormally low and deflated base. It’s helpful to look back at last year to understand why this happened.

Last year uncertainty gripped the market and caused commodity prices to crater to historic lows. On April 20, 2020, West Texas Intermediate (WTI), the US oil benchmark, ended the trading day at negative $37.63 per barrel. Those rock-bottom prices played a role in the deflationary data at the time. Fast-forward to today; comparing the current environment to an abnormally low CPI month like April 2020 can be misleading.

This becomes more evident when we look at the graph below. If we grew the January 2020 CPI at an annual rate of 2.5%, ignoring the extreme drop in prices that was recorded in April 2020, the May 2021 CPI number would be almost directly in line with the trend. This is indicative of prices returning to normal after a global crisis, not of 4% inflation crippling the economy. 

Figure 1: Consumer Price Index (Jan 2018 to April 2021)

Source: Bureau of Labor Statistics, as of June 1, 2021

Temporary shocks in specific parts of the market

Last month’s inflation number was not just a byproduct of a low base. Some items used in the calculation of CPI saw moderate, but in our opinion temporary, increases. 

For example, used cars were the biggest contributor of the 4.2% YoY increase. Prices of previously owned vehicles jumped 10% in April, which was the largest increase ever recorded in used cars in the CPI data.2 Much of the increase came down to a semiconductor shortage that slowed down or halted production of new cars. 

Although trends like these are newsworthy, they are unlikely to persist: as the global economy recovers from the pandemic, the supply of semiconductors should return to normal levels. The reopening of public transportation options may also reduce the demand for used vehicles. 

How does this translate to your portfolio allocations?

Inflation is often presented as a terrible bogeyman gobbling up purchasing power, but the truth is that capital markets have historically provided returns that more than offset inflation’s effects. The best course of action, in our opinion, is to remain inflation agnostic. For those investors who still have a heightened sensitivity to inflation, there are a few options that may help provide additional protection. 

Diversify with a global portfolio

A global equity portfolio provides diversification and mitigates the effects of any one country’s economic situation on your overall portfolio. While we live in an increasingly connected world with an integrated global economy, the economic conditions of countries around the globe are not homogenous. The United States experiencing unwanted inflation does not necessarily mean that other countries will. Furthermore, if the US Dollar weakens, the exposure to foreign currencies can offer protection. When the dollar weakens, dollar-denominated returns in foreign equities are higher. 

Consider an allocation to TIPS 

Treasury inflation-protected securities, or TIPS, are US government Treasury securities that provide protection against an unexpected decline in investors’ purchasing power. The bonds are indexed to a measure of inflation; the principal value rises as inflation rises. 

Reduce the duration of your bond portfolio 

If the Fed were to raise interest rates, a common tool they use to stave off inflation, the market value of fixed income securities would fall. Reducing the duration of a bond allocation may protect fixed income allocations from the effects of rising interest rates. 

***

Inflation is likely to remain a hot topic in 2021 and possibly beyond. High year-over-year CPI increases are likely to persist through 2021 because of the low base numbers seen at the height of the pandemic in 2020. We are also likely to continue to get some surprises like we did with used cars, as the forces of supply and demand settle. Fortunately, capital markets have historically provided returns that outpace the purchasing power degradation that inflation poses.For investors with heightened sensitivity to these effects, there may be sensible, easy to implement ways to protect their portfolios. 

Footnotes

1.  Proposed $1.8 Trillion in spending and Tax Credits; $2.25 Trillion in Infrastructure, home health care, etc.; and $5 Trillion: 3 Pandemic relief packages

2. The Bureau of Labor Statistics data begins in 1953.