Inflation: What to Know
Enjoy this week's edition of the Planner's Beta
Beta (n) - climber's jargon that designates information about a climb
Inflation and the Markets
Markets are jittery. First, U.S. equities are at valuations not seen since the dot-com bubble. Second, markets are digesting the prospect of heightened inflation. Let's dive into the data to understand better what is going on in the markets. First, let's look at valuations. When we look at the price investors are willing to pay for future earnings of stocks, we see that U.S. equities are the most expensive since the dot-com bubble. This doesn't necessarily mean U.S. stocks are in a bubble. If prices remain constant and future earnings continue to grow, we can expect PE ratios to decline, and equities will not seem expensive. But lofty valuations mean market participants are susceptible to new risks appearing on the horizon. One of those risks is increased inflation.
Inflation expectations are heating up. First, what is inflation? Inflation is when the general level of prices for all goods and services increases. And, this morning, the consumer price index, a measure used to track inflation, published a 4.2% reading, with the core reading (ex-food and energy due to their volatility) sits at 3.0%. It is a high number. However, this high reading is due partly to such low prices a year ago because of the pandemic shutdowns (know as the base effect). These numbers on the surface are concerning, and investors and savers are correct to feel concerned. But, to have a clear understanding of what is behind the numbers and where to expect inflation to be in the future, we should look deeper.
There are two forms of inflation. The first form is when prices increase due to an imbalance between supply and demand for goods and services. The second form of inflation is from the excess supply of dollar bills in the economy.
Let's look at the first form of inflation. We can see housing prices increased over the past year. And lumber, copper, and corn, critical commodities for the economy, increased in price over the past year. These commodities represent necessary inputs for many finished goods. Rising input costs for producers can trickle into the prices consumers pay for goods and services. However, are these price increases due to money printing or supply chain disruptions from COVID-19? The increases are likely more from supply shocks and changing demand. However, as supply chain issues are resolved and demand responds to increased prices, commodity prices will probably revert.
Now let's investigate the second form of inflation caused by excess money in the economy. This form of inflation can be destructive, and investigation into this form of inflation is warranted. It is justified because the central bank has printed a lot of money. The central bank printed so much money because it does not expect sustained inflation beyond this year. Remember, Congress tasks the Federal Reserve to promote stable prices and full employment. The Fed is currently concerned with deflation and high unemployment. These concerns are why the Fed is pumping money into the economy, hoping these policies support the economy's expansion while avoiding declining prices. The central bank indicates they will not tighten money creation anytime soon. Jerome Powell, the Federal Reserve Chairman, continues to iterate the economy will experience a transitory period of inflation. These statements, coupled with the bank's guidance last year, have market participants questioning how high officials will allow inflation to go. All of this leads to uncertainty. And, in general, markets don't like uncertainty. Uncertainty's brother, risk, is what pushes investors to take bets off the table and reposition strategies, causing asset prices to decline. Is the excess supply of currency relative to goods and services in the economy out of control? As we can see with the five-year and ten-year breakeven rates (a measure between Treasury notes and Treasury Inflation-Protected Notes), inflation expectation sits at about 2.5% for the next ten years. Yes, inflation expectations rocketed to highs not seen in the past ten years, but the past ten years is an aberration of the long-run average for inflation, which sits closer to 3%. Additionally, these expectations are nowhere near the inflationary pressures felt during the late 70s and early 80s.
Savers and investors are correct to be vigilant against inflation. And we should remain vigilant by holding well-diversified portfolios that account for both inflation and deflation risks. However, it is not clear the dangerous form of inflation (money printing) is out of control. I say this because there are significant headwinds facing inflation for it to ramp out of control.
First, money velocity remains at all-time lows. Money velocity is a measure of how many times money turns over in the economy. If the Fed prints a ton of money, but that money is not moving through the economy (a pandemic sure puts the breaks on spending money), the likelihood of inflation kicking off decreases. For inflation to kickoff, an increase in cash in the system has to increase significantly more than the decline in velocity. It is not clear we have reached that inflection point.
Second, unemployment remains high, and labor force participation rates are at multi-decade lows. With fewer people working, wages (a pivotal input to prices) will likely remain subdued over the medium term. There is anecdotal evidence companies cannot fill jobs (and yes, there are about 8 million jobs available). But approximately 9 million laborers are looking for work. And when we account for such a low labor force participation rate, when the economy fully opens up, we should expect disenfranchised workers to reenter the labor market.
And third, technology has drastically changed the economy over the past two decades, and these fundamental changes in the economy will be with us for years to come. With increased productivity and the advent of the gig economy, capacity measurements are not what they used to be in the past. Productivity reduces inflation pressures. A lot has to go wrong for inflation to be anything like the 70s and 80s.
If inflation does take off, the central bank has many tools at its disposal to rein in inflation. Policymakers learned many lessons from the inflationary period 40 years ago. One lesson learned from the 70s and 80s is the importance of a credible central bank. A credible Fed is a key to managing inflation expectations. I will not be surprised at some point when (or more likely if) inflation reaches a sustained rate beyond the bank's inflation target range that there are swift and significant actions taken to control inflation. Those policies may include drawing down on quantitative easing, raising rates, and revising policy.
Inflation concerns have many investors questioning U.S. equity valuations. The heightened prospect of inflation increases planning and execution risks for businesses and households in the near term. However, as long-term planners, we need to be careful not to predict when to time the market. Fears of inflation are valid. But the risk of inflation is omnipresent. And it is why we design and implement portfolios and plans to account for these risks, even when these risks are not making headlines.
Financial planning is a process. And such market concerns should remind you to reflect on your risk tolerance, needs, and capacity when making investment decisions. A renewed focus on why you save, when you need your savings, and your resolve to stick to your plan in up or down markets, should remain front of mind.
Linked here is a more comprehensive review of domestic and international bond and equity market news from Q1 2021 (courtesy of XYIS, Pursuit Planning and Investments, LLC investment management platform). As always, I encourage you to remember:
Financial planning is a process
Focus on reaching your goals
Maintain a discipline
Diversification is key
Manage investment and tax costs
Rebalance portfolio as needed
This Month's Financial Planning Item - Reviewing Your Tax Return
Tax day is May 17th! Don't just throw your tax return in a file after you submit the paperwork to the IRS. Review the paperwork for accuracy and planning opportunities!
Reviewing your tax return can always be an informative exercise to ensure you understand all sources of your income and your tax liabilities for the prior year. Additionally, it can help you uncover potential planning opportunities for future years.
This month I encourage you to review your tax return. This checklist highlights points to consider on your tax return (and how to identify issues), including:
Review your filing status. Consider if you are married if you should automatically file jointly with your spouse, or might there be situations where it might make sense to file separately?
Review if you are taking advantage of all the tax benefits that come with having children.
If you are getting divorced or lost your partner, are there filing steps to take depending upon timing and circumstances?
If you had investment income for the prior year, are there reporting issues that you will want to be sure are correctly addressed regarding this income.
If you owned tax-advantaged accounts during the prior tax year, you should consider some reporting items. Did you convert a traditional IRA to a Roth? Did you contribute to an HSA or a 401(k) plan? Be sure to review if these items are correctly captured on your return.
If you own rental real estate, be sure to check to see if there are state-specific issues to consider.
This checklist provides the types of issues that taxpayers should review each year. It gives details on where to look within your return to find items to review.
For current clients of Pursuit Planning and Investments, LLC, you will receive a Precise FP form notification via a separate email, asking you to upload your tax return and recent paystubs securely. In our next meeting, I will review your tax return with you to uncover any potential opportunities. We will discuss your effective tax rate, marginal tax rate, credits claimed, and tax planning opportunities in that meeting based upon your unique situation. The PreciseFP engagement includes the checklist mentioned above.
If you are not currently a Pursuit Planning and Investments, LLC client, feel free to review our tax return review service and place a commitment-free discovery meeting on my calendar.
Have something on your mind? Schedule a free call with Nate.
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