As we all know, increased inflation has set in on the U.S. economy. Spending habits for consumers will change as purchases are postponed and household sacrifices are made. But what does inflation due to the investment sector of the economy?
Higher Interest Rates Inhibit Development: Long-term investing that leads to development is especially impacted by higher interest rates. If a group of investors plan to build a large industrial complex, for example, their planning usually includes some form of measuring future returns. Expected future returns are then discounted back to the current date at nominal rate to determine the estimated present value of the project before any commitments are made. The range of these expected returns is at least ten and perhaps as many as fifty years. This great uncertainty can be compounded if inflation has set in to the economy, as the potential cost of the project, which may take years to build, will be impacted in ways that cannot be feasibly estimated. Further, the present value becomes uncertain as the discount rate used to determine it would not be uniform over the same lengthy period period of time.
Should the On-going Inflation Rate Still Be 2%: For many years now, the Federal Reserve and other central banks have used various monetary policy tools to keep the rate of inflation for the economy down to about 2%. This targeted number seems to have been a satisfactory benchmark for most of the many years that inflation in the U.S. economy has been kept under control. But bringing it down from nearly 10% to 2%, although possible, could cause serious pain in the economy and political backlash. Strong forces such as shrinking workforces and delicate supply chains have been directly involved with the current round of inflation and might not be easily ameliorated. Unusual demand brought about by increases in defense spending owing to the Ukraine War, and the heavy investments needed to fight global warming adds to the difficulty of cooling down the economy. We could see that the fed’s fine tuning gets it down close, but not equal to the 2% figure, creating what amounts to a new normal of 2.5% to 3%.
Fixed Investments Face Erosion Over Time: During periods of inflation, bonds, notes, and other fixed investments face an erosion of value for the investor over of time. There is more compensation for risk, but careful planning and use of a bond ladder are required to protect this erosion from becoming excessive. Bondholders are compensated more for holding longer term bonds, but if inflation remains high over longer periods of time, the erosion effect could substantially reduce the gains. There is some relief from the TIPS, or Treasury Inflation Protected Securities, as the principal amount of the investment is adjusted twice a year for inflation as per the Consumer Price Index. However, the returns for TIPS are usually lower than those for regular bonds, a fact that must be considered before investing. Further, when inflation slows down, the biannual adjustments also slow down. Another downside to buying inflation protection securities is that during the start of inflation, the demand for TIPS increases dramatically outstripping the supply making them harder to find or purchased at a premium.
Equities Cannot Outpace Inflation in the Short Run: The value of a stock is usually derived from the underlying company’s earnings. As prices rise and outpace costs, there should be an increase in value. But for many companies the major component costs such as materials and labor could rise faster than the prices of the finished product. Consumers will often put off major purchases in the face of the uncertainty brought about by inflation. Further the track record of equities during inflation is not good. In the years since 1900 that inflation rose above 7.5%, the average inflation adjusted return on equities fell from positive to negative. In those years that inflation was up, but not above 7.5%, notable erosion in equity values took place. Stocks will likely outpace inflation in the long run, but in the near term they cannot act as a hedge in every case.
Other Asset Classes May Fare Better: Investment property or infrastructure will hold value much better than most asset classes during inflationary periods. While the fixed costs should rise very little, the revenues from rents or usage fees can generally be increased to match inflation. The demand for investment property may also increase as other investors look for inflation fighting alternatives. Commodities also generally will outperform stocks and bonds. During periods of above normal inflation, commodities futures have averaged as high as 11.4%. This trend can also continue if inflation combines with low or negative growth to create a period of “stagflation.” However, neither investment property nor commodities can easily provide a safe haven for securities investors owing to the difficulty and length of time to acquire and/or liquidate. Such investments serve best as “buy and hold,” and should already be in an investor’s portfolio before inflation hits.
Asset Managers Struggle Also: Periods of inflation don’t make matters easier for most asset managers, many of whom struggled to beat the S&P 500 during years of low inflation. This would be in part owing to the fees charged (usually 1-2% annually) that would pull down on the fund’s performance. Rare exceptions can occur for those managers who are able to sort out the timing of inflation ahead of time, and pick those securities that are likely to gain in spite of the impending inflationary economy.
Governments May Actually Appreciate Periods of Inflation: Governments in most parts of the entire world are grappling with massive amounts of debt. From the financial crisis of 2007/8 through covid-19 and now Europe’s energy crisis owing to the Ukraine War, the amounts of debt controlled by governments is staggering. However, the longer inflation lasts, the less that debt is worth, and the cheaper it is to liquidate when due. Major growth is the best way to deal with such amounts of debt, but it is also the chanciest and most difficult to maintain. Other measures to deal with it are politically unpopular—tax increases and spending cuts. But what happens when a government’s credit rating is affected by the management of debt, and investors become wary of the borrower’s credit worthiness? Then the unpopular solution is the one that must take place, and many investors may reach the conclusion that government bonds are not as safe an investment as they once were.
Conclusions: The current inflation appears to be slowing down. This, of course, is good news for nearly everyone, but when will higher interest rates recede? The answer here is much harder to find. Should central banks lower interest rates too soon, then the likelihood of a return to inflation, and another rate tightening cycle, becomes real. Even with steady progress in fighting inflation, I would expect a lengthy pause to appear and the threat of recession to materialize before any significant interest rate easing begins. How long? It’s very difficult to tell, and the near-term criteria is compounded by the coming presidential election now about fifteen months away.
Sources: The Economist, A Steady Grind, June 24th 2023.
Walletgenius, Treasury Inflation Protected Securities (TIPS): What You Need to know, by David Ning, August 31, 2021.