Inflation

Inflation, Inflation, Inflation! You can’t turn on the TV without hearing someone talk about inflation and rising prices. And, once in a while, you hear a quote that actually makes sense, like these:

• “Inflation is taxation without legislation.” Milton Friedman
• “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Ronald Reagan
• “Every portfolio benefits from bonds; they provide a cushion when the stock market hits a rough patch. But avoiding stocks completely could mean your investment won’t grow any faster than the rate of inflation.” Suze Orman

According to thebalance.com, we have not seen really high inflation since the early 1980s, amidst a rash of savings and loan failures and a recession. Here is how inflation has looked since the mid-20^th century:

Now with the Federal Reserve set to raise rates three times next year, I thought it might be prudent to talk about inflation.

Here is what Fed Chairman Jerome (Jay) Powell had to say in his press conference last week:

“Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. In particular, bottlenecks and supply constraints are limiting how quickly production can respond to higher demand in the near term.

“Overall inflation is running well above our 2 percent longer-run goal and will likely continue to do so well into next year. While the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, price increases have now spread to a broader range of goods and services. In light of the strengthening labor market and elevated inflation pressures, we decided to speed up the reductions in our asset purchases.”

The result of those statements: The Federal Reserve is tapering off its bond buying faster to decrease economic stimulation. Tapering is now scheduled to be completed by March. And most of the Fed officials are now estimating that we will see “at least three more rate increases in 2023 and two more in 2024.”

Last September, the Fed officials thought rates would rise to 1.625% by the end of 2023. That view has now changed to around 2.25%.

What is Inflation?
I know the average person’s eyes glaze over when you hear the word “inflation.” Most of us know the bad effects of inflation: rising prices and increasing interest rates. That sounds like a simple catchphrase, doesn’t it? But, bottom line, both consumers and investors need to know two things: 1) how inflation will affect their daily lives; and 2) is there anything you can do to soften and/or combat those effects to help you ride out—and prosper—from the coming inflation storm?

So, let’s try to break it down into an understandable and actionable strategy.

First, here’s the definition of inflation, courtesy of Investopedia.com: “Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.”

Translation: inflation means every one of your dollars will buy less goods and services.

Inflation can be measured in many ways, but the most common measures is the Consumer Price Index for Urban Consumers (CPI-U), maintained by the Bureau of Labor Statistics. The CPI-U shows changes in the prices paid for a “representative basket of goods and services.”

The four major categories of purchases in the CPI-U are food, energy, commodities, and services.

The Pros and Cons of Inflation
We’ve already discussed how inflation can erode your purchasing power through rising prices and higher interest rates. But let’s delve a bit deeper to see some of the other good and bad points about inflation.

Pro: The fear of inflation can cause us to buy more now, and that helps keep the economy on a growth track.

Con: But it can also cause more inflation, even hyperinflation. For example, that fear can increase spending as consumers worry about more and steeper inflation, which adds higher amounts of cash to the economy, increasing the money supply. As the money supply expands beyond demand, your purchasing power will fall even faster. And the extra spending can lead to hoarding (as we saw during the early stages of the pandemic), depleting retail shelves, and eventually can lead to hyperinflation.

This happened in Germany in 1923, when an index of the cost of living in Germany increased to a level of more than 1.5 trillion times its pre-WWI measure. We’ve seen it more recently in Venezuela, as the inflation rate reached 800% in 2016, over 4,000% in 2017, and about 1,700,000% in 2018. Now, no one is predicting hyperinflation for the U.S., but it’s good to understand how it comes about.

Con: Inflation can also reduce employment and growth and create stagflation. That’s a period when “growth is slow, unemployment is high, and inflation is in the double digits.” The term was coined by a British Tory MP in 1965. We saw stagflation in the Nixon era. It was called the “Nixon shock.” Former president Richard Nixon, hoping to decrease inflation, protect the U.S. dollar and create better jobs, implemented three things:

• A 90-day freeze on wages and prices
• A 10% tariff on imports
• The removal of the U.S. from the gold standard

Removing the gold standard caused a rapid decline in our dollar, compared to other currencies. Then, the Federal Reserve raised interest rates to fight inflation that it had created by pumping money into the economy, at almost twice the rate of GDP. Most economists labeled that, “too much money chasing too few goods.” Next, we suffered a drop in productivity, and then unemployment rose.

On top of that, OPEC instituted an oil embargo in 1973 that sent oil prices skyrocketing, along with heating bills (I remember wearing a coat and gloves in my office, where the temperature was set to 55 degrees!). All of these events caused stagflation, and then a recession.

Our economy survived both and then Reagan was elected, reduced taxes and tightened the money supply, and, gradually, the economy recovered.

Pro and Con: Wage inflation. While your wages may be rising during inflation, so is the cost of pretty much everything else. Net-net, you may be a little behind or a little ahead.

Pro: Inflation can reduce unemployment. Economists say that once inflation hits a certain rate, employers’ real payroll costs fall, and they’re able to hire more workers. This inverse relationship is explained by the Phillips curve:

According to Investopedia.com, “As unemployment falls, the theory goes, employers are forced to pay more for workers with the skills they need. As wages rise, so does consumers’ spending power, leading the economy to heat up and spur inflation; this model is known as cost-push inflation.”

So, as you can see, inflation isn’t always all bad.

What Rising Inflation Means to the Consumer
The chart below depicts the one-year change in the price of products that we buy every day. As you can see—and feel at the gas pump—energy prices have risen most of all.

Breaking down the categories even further, the U.S. Bureau of Labor Statistics cites these price increases, year-over-year, as of November:

• New vehicles, 1.1%
• Used vehicles, 2.5%
• Fuel oil, 3.5%
• Apparel, 1.3%
• Gasoline, 6.1%
• Rental cars, 40%

What does this mean for you? Well, according to the U.S. Energy Information Administration (EIA), 2022’s heating bills will be much higher: 54% more for propane, 43% more for home heating oil, 30% more for natural gas and 6% more for electric heating. Your heating bills will vary by state. Here in Tennessee, the average monthly bills are $132.33 for electric and $46.17 for natural gas. We can expect both to increase next year.

Last year, the average new car sold for $46,300 and a used car averaged $27,500, says Kelley Blue Book. The incredible rise in auto prices in 2021 was mainly due to a shortage of microchips. Experts believe this will abate somewhat next year, but prices are expected to continue to rise, albeit at a slower pace.

Inflation, by the end of 2022, is expected to average 3.8%. That means that if you buy $100 worth of food today, that same food will cost you $103.80 next year. But if you buy an automobile today for $46,000, next year, that same car might set you back $47,748 (or more!).

But if you take out an automobile loan, you will be doubly affected—by not only the rising inflation rate, but also the increasing interest rate. Currently, the average national auto loan rate, according to cars.usnews.com, is around 6.21% (for a 750+ credit score; higher if your credit score is lower). Next year—depending on when you buy—the rate could be 1.25% higher. That means, on a $45,000 loan, your payment would go from $874 per month to $901.

And if you decide to buy a home next year, your adjustable-rate mortgage that is priced at an average rate of 4.604% today, at 1.25% higher, will increase the monthly payment of a $300,000 mortgage from $2,052 per month to $2,361. Now, we’re talking big numbers, hmm?

Next, let’s look at the steps you can take as a consumer to help mitigate the effects of inflation.

Step 1: The Consumer Products You Might Want to Buy Now Instead of Later
Energy. If you use propane for heating, you might want to buy a larger tank, or at the very least, make sure your tank is topped up.

Food and staples. I don’t want to encourage anyone to hoard, as we still have a significant supply chain snafu. But if you have a freezer and/or a large pantry, you might want to stock up a bit.

Apparel. Prices may not rise as much as other categories, but if you have children, you might want to think ahead, and buy clothing and shoes in the next size up.

Automobiles. According to joinya.aaa.com, there are usually two-three million new cars available at any time in the U.S. That number is down to one million, less than a one-month supply. For some vehicles, the wait to get your new car is an entire year! The good news is, as I mentioned earlier, the chip shortage should be abating next year, which should help increase inventory. But, as I also said, auto prices will be rising, so if you know you’re in the market for a new vehicle, you have the time to wait for it, and can order at a guaranteed delivery price, now might be a good time to indulge yourself.

As for used cars, as the new car market strengthens, the used car market should begin to return to normal, with more down-to-earth prices, so if you can delay your purchase, I might recommend that you wait to purchase a used vehicle until that happens.

Vacations. Of course, no one knows when COVID-19 will allow us to return to a business-as-usual travel environment. I’ve already canceled a few trips, including a river cruise in Europe (darn!), and have no idea if my scheduled September 2022 Alaskan trip will materialize. But, so far, the tour operators have been really good—and quick—in returning deposits. I’m sure, once we get rid of the pandemic, vacation prices will rise. So, if you want to take a nice trip, you may want to plan it now, and get your price guaranteed with a deposit.

Mortgages. If you’re in the market for a home (and you can find one!), you might want to take advantage of the lower rates right now.

Step 2: Pay Down Some Debt
As interest rates rise next year, so will the price of the debt you are carrying. So, you may want to consider reducing, eliminating, or refinancing some of your debt balances, like:

Adjustable-rate mortgages. Now is the time to refinance any adjustable-rate mortgages into fixed-rate. That will have two advantages: 1) it will lower your interest rate (probably); and 2) you won’t have to worry about the Fed’s interest rate increases.

Student loans. The current average national rates on student loans are 4.53% for undergraduate students and 6.08% for graduate students (plus lots of other fees!) The federal student loan rates are tied to the 10-year Treasury note, but just about all of the private loans are also priced with variable rates, so your costs will definitely be going up as rates rise. If you can whittle those balances down now, you’ll save yourself a bundle of money in the future.

Credit cards. Wallethub.com says that the average rate on credit card balances today is 14.54%. Those rates are also variable, mostly based on the prime rate plus. Credit card interest rates are some of the first to rise when rates go up. I’ve never noticed that they’ve fallen when rates decline. Have you? We wish. However, paying down those balances now will save you a lot of money down the road.

What Rising Inflation Means to the Investor
We’ve talked a lot about the effect of inflation on consumers. But inflation also affects your investments. On the investment side, it’s a mixed bag, as to the effects of inflation.

As you know, if you are a bond investor, or just buy certificates of deposit at your bank, your investments generally come with a fixed interest rate. That means that, while you may earn the same amount of money from those investments each year, those earnings will buy you less and less as inflation accelerates. According to nerdwallet.com, the average one-year CD rate is currently 0.14% APY, and the average rate for a five-year CD is 0.24% APY. That certainly won’t shore up your purchasing power.

However, if you own stocks, you will most likely be in a better position. As an economy grows, so does inflation. That generally will translate to higher prices of goods that a company sells, and should lead to rising earnings, which usually push a company’s share prices higher. However, while prices are rising, so are the costs to make those goods, as well as wages, so earnings may not grow as fast as you think. In a period of rising inflation, it’s essential that you invest in stocks that can perform well during those economic cycles. I’ll talk more about those in a minute.

In the long term, equities have been pretty good hedges against inflation. On a split-adjusted bases, Apple (AAPL) stock closed its IPO on December 12, 1980, at $0.10. As I write this, the share price of AAPL is $174.27. That’s an increase of 17,417%; $100 invested in AAPL stock in 1980 would be worth $174,170 dollars!

Now, if you had invested that $100 in the ICE BofA AAA US Corporate Index Effective Yield (corporate bonds) at the same time, you would have $799 today. And if you stuck it under your mattress, it would be worth $337.32, counting inflation. That means that you would need $337.32 to buy the same amount of goods that $100 bought 21 years ago.

Many gold bugs will tell you that gold is a perfect inflation hedge. But, according to Mark Hulbert, in a recent Wall Street Journal article, that’s a “golden” myth. Mark noted, “If gold were a good and consistent hedge, the ratio of its price to the consumer-price index would have been relatively steady over the years. But that hasn’t been the case, over the past 50 years, the ratio has fluctuated from a low of 1.0 to a high of 8.4.”

Further research by Duke University professor Campbell Harvey and Claude Erb, a former commodities portfolio manager at TCW Group, found that “it’s only when measured over very long periods—a century or more—that gold has done a relatively good job maintaining its purchasing power. Over shorter periods its real, or inflation-adjusted, price fluctuates no less than that of any other asset.”

Conclusion: buy the right stocks, at the right price, to shore up your portfolio against rising prices.

Next, let’s talk about which types of investments you should be pouring your money into now, so that you can take advantage of rising prices, and then we’ll narrow our search to specific investments.

Step 1: Which Investments Products Do You Want to Buy or Add to Now?
Stocks, ETFs, and Mutual Funds, High Yield Bonds, Inflation Protection Investments, Real Estate, and Commodities. I’ll get to those in a minute.

529 plans. This investment is for education. A 529 plan offers tax benefits (similar to a Roth IRA, investing before-tax dollars), if you use it to pay for qualified education expenses for a designated beneficiary. The funds in a 529 plan can be used to pay for college, K-12 tuition, apprenticeship programs, and student loan repayments.

Just about every state offers 529 plans. There are no annual contribution limits, but each state o has an aggregate contribution limit for 529 plans, which ranges from $235,000 to $529,000, depending on average college costs in the state.

Here’s a link to find out more about your state’s 529 plans.

Also, please see my article with much more details about the plans:

Retirement accounts. Whether you have a traditional or Roth IRA, or some other type of retirement account, the more you put into it now, the more likely your money will grow over time.

Here are the current contribution and income limits on IRAs and Roth IRAs:

Traditional IRA income limits in 2021 and 2022

Note: Traditional IRA income limits apply only if you (or your spouse) have a retirement account at work.

Roth IRA income limits in 2021 and 2022

Source: nerdwallet.com, MAGI=modified adjusted gross income

Step 2: Which Investments Tend to Fare Better or Worse During Periods of Rising Inflation?
Since value stocks generally have strong and current cash flows, while growth stocks normally have little cash flow today (in hopes of more tomorrow), value stocks tend to outperform growth stocks in periods of rapidly rising inflation. Value stocks such as consumer staples and energy tend to do well, as their demand is inelastic—we always need their products.

And because income-producing stocks generally pay dividends which do not normally keep pace with rising inflation, these stocks tend not to fare that well during those economic cycles. The exception would be high-yield stocks (as long as their fundamentals are strong).

Small-cap stocks tend to do better when prices are rising, due to both great growth expectations and their cheaper valuations.

Treasury Inflation-Protected Securities (TIPS) and high-yield bonds. TIPS offer interest rates that are indexed to inflation, which causes them to pay more in interest while also increasing the principal value of the security.

At the same time, you would want to reduce your exposure or stay away from Treasuries, as they are more sensitive to inflation.

Real estate and commodities. As you can see, housing prices have been on a real upswing this year. And Zillow predicts they will rise by 13.6% in 2022. That being the case, and as I said earlier, now may be the time to invest in a home or buy a housing real estate investment trust (REIT). And don’t forget about energy, the fastest-rising commodity.

Also, building prices continue to rise, up 116.9% this year, according to eyeonhousing.org, so investing in a stock that provides such commodities may be a good idea.

Diversify and rebalance often. In order to get the most out of your holdings, you need to diversify in terms of types of investments, market caps, and industries. And a portfolio should not be static. I recommend that you rebalance at least once a quarter.

5 Investments for Rising Inflation
These next few investment ideas are just that—some possible ideas to shore up your portfolio to protect it from and to profit from an inflationary environment. I’ve done a bit of research on each, but only you will know if any of these ideas fits into your investment strategy.

Prologis Inc. (PLD), a logistics REIT that pays a 1.56% dividend. The REIT beat earnings estimates by $0.45 last quarter and is expected to sport growth of nearly 14% this year.

Pimco 15+ Year U.S. TIPS Index ETF (LTPZ) is made up of Treasury bonds and pays a current annual dividend yield of 2.05%.

Home Depot (HD), a perennial investor favorite, beat analysts’ earnings estimates by $0.52 last quarter and pays an annual dividend yield of 1.69%. Although the shares of HD have risen some 110% since the beginning of the pandemic, most industry analysts believe the strong housing market will continue to boost them.

Vanguard Real Estate ETF (VNQ) pays a dividend of 2.19%, and the top five holdings include: Vanguard Real Estate II Index (VRTPX, 11.53% of assets); American Tower Corp. (AMT, 7.49%); Prologis Inc (PLD, 5.62%); Crown Castle International Corp. (CCI, 4.69%); and Equinix Inc. (EQIX, 4.23%).

S&P 500 Materials Sector SPDR (XLB) has a dividend of 1.63%, and its top five holdings include: Linde PLC (LIN.L, 15.91% of assets); Sherwin-Williams Co. (SHW, 6.90%); Air Products & Chemicals Inc. (APD, 6.74%); Freeport-McMoRan Inc. (FCX, 5.75%); and Ecolab Inc. (ECL, 5.42%).

Now, the investments above are pretty vanilla. And beginning investors may want to start out with the ETFs. But if you want to walk on the wild side, gold believers may choose to invest a little in SPDR Gold Shares (GLD) or be more speculative with a cryptocurrency fund like First Trust Exchange - Traded Fund VI - First Trust Indxx Innovative Transaction & Process ETF (LEGR), which tracks the Blockchain Index.

Whatever you decide, just make sure the investment fits your risk profile and strategy.

Happy investing!