Each year, it seems there is a “buzz word” used in every news story about the economy or the markets. This year everyone is talking about inflation. Inflation is defined as an increase in prices occurring simultaneously with a fall in purchasing power. Or in other words, trying to buy a product that is increasing in price as the dollars you are using are worth less. By that definition, deflation is the reverse, a decrease in prices with an increase in purchasing power. You likely have noticed some of the impacts of inflation or have heard stories recently of crazy prices paid for items. It’s popped up everywhere, at the grocery store, the lumber aisle at your favorite DIY store, and, yikes, have you tried to buy a house or used car lately? What should we make of all this? It’s a topic with no shortage of opinions; ranging from runaway inflation fears to ‘this too shall pass’. The reality is likely somewhere in-between. Let’s take a look at how we got to this point, and if it should impact how we invest your money.
When COVID came into full view in the first quarter of 2020, the world experienced rolling lock downs for several months. The economic impact was massive, as demand for goods and services was drained out of the system. People weren’t going out to eat, schools closed, vacations were canceled. Zoom meetings and working from home quickly became the norm. From an economic point of view, this was a negative demand shock and caused significant deflation (remember how cheap those airline tickets were in 2020). In an effort to stabilize markets and the economy, The Federal Reserve (the Fed) and Congress took unpresented steps which lead to an increase in the Federal Reserve’s balance sheet to over $8 trillion.
Raising the balance sheet of the Fed funded massive stimulus programs in the US, sending money to businesses and people in an attempt to increase demand by flooding the economy with liquidity. This strategy was adopted across the world by other governmental bodies. When we combine a massive increase in liquidity across the globe with economies and industries all opening at varying speeds, it creates the perfect recipe for inflation.
Let’s take the cost of lumber for example. Undoubtedly, it’s been an eye opening seeing the price of 2x4’s at Home Depot.
When COVID hit, a lot of lumber mills closed or slowed production; trees were not being farmed as demand dropped off and health conditions had many companies reducing staff. Meanwhile, governments started their programs to stimulate the economy, including sending checks directly to individuals. Now we have low supply of lumber, lots of people at home with home improvement ideas, and a big supply of dollars – instant inflation! In the past few weeks, lumber mills have started to catch up a bit and we’ve seen prices start to come back from their astronomical highs. This movement is what the Fed calls ‘transitory inflation’, while inflation did occur, the Fed expects costs to consumers to return to a normal range as supply catches up with demand. This type of price movement can be seen in other sectors and commodities, such as with used car prices and semiconductor shortages.
Visually, we feel the best way to describe inflation is through a ‘bull whip’. Just like a bull whip, the extremes of the high and low are always greatest on the early end, and eventually even out at the end.
At this time, the economy is likely past the first peak of the whip as the biggest stimulus measures are likely behind us. It is likely we’ll see more, but they will be much smaller in comparison. For the road map ahead, it’s important to remember that there are many factors that can trigger or exacerbate inflation and deflation, and it’s impossible to predict accurately in the future when they will appear and the severity of their impact.
Inflation Triggers:
• Economic Stimulus
• Rapid Growth
• Wages Increases
• Shortages (labor, commodities, etc.)
• Relaxing of Monetary Policy
• Increasing Fiscal Spending
Deflation Triggers:
• Technological Advances
• Improved Efficiency
• Surpluses (labor, commodities, etc.)
• Slowing Growth
• Tightening of Monetary Policy
• Decreasing Fiscal Spending
As different factors drive inflation and deflation, they each can create a divergence in the performance of asset classes. So, what does this mean for your investment strategy? Imagine a field with so much water on it, it just simply sits. The ground is so saturated, the water has nowhere to go. In short, this is the global economy at this time, so much liquidity, it just doesn’t have anywhere to go yet. This will take time, and it is likely not going to
happen in a straight line. Knowing this informs us to balance asset allocation decisions for both inflationary and deflationary environments by being broadly diversified. It also creates rebalancing opportunities between asset classes where dislocations continue to occur as liquidity is absorbed into the global economy. In other words, our strategy to keep accounts broadly diversified and to rebalance back to targets will position you to take advantage
of the inflation bullwhip to come. While we do not know what will happen for certain with inflation and the market, time has shown that ‘betting’ on the best or worst scenarios are just that – bets. We remain disciplined in our investment approach and continue to rebalance as opportunities present themselves through market dislocations.
If you have questions about your financial plan or investment strategy, please contact your Cassady Schiller Wealth Management Advisor.
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