Inflation: How Should Investors Prepare for the Future?

Recent data on inflation reminds us of the famous Sherlock Holmes “dog that didn’t bark.” Despite numerous warnings from financial-market pundits that inflation is just around the corner, inflation statistics remain benign and surveys of inflation expectations suggest that price-level expectations are well contained.  So what is the outlook for inflation? Are there reasons for complacency or are there reasons for concern? And if inflation is a threat over the longer term, how should investment portfolios be allocated so as to mitigate the risk?

A New Era of Price Stability?

Those who are sanguine about our ability to maintain price stability argue that the world economy is beset by a condition that might be described as one of “secular stagnation.” Our global economy seems capable of producing an inexhaustible supply of goods. The U.S. used to be a less open economy with a relatively fixed productive capacity. Today, the U.S. market is served by manufacturers from Europe to the Far East. Even services are provided globally, ranging from customer service centers to providers of architectural and legal services. At the same time aggregate demand has been constrained by a large overhang of debt and fiscal headwinds. The view of many economists is that global aggregate demand will not be sufficient to absorb the bountiful aggregate supply for years to come.

Bargaining power has shifted from weakened unions to employers. Wage growth has been anemic and rising unit labor costs (a feature of the inflation of the 1970s) is a condition of the distant past. And deregulation in fields such as transportation and communications has also contributed to competitive pricing and the widespread belief that inflation is dead.

Is Inflation Dead? Don’t Bet On It.

Before we get out our party hats and celebrate this new era of price stability, let’s examine the arguments suggesting that inflation is not down for the count. Remember that the developed world has just now recovered from the deepest global recession since the Great Depression of the 1930s. In the United States slack in the labor market has markedly decreased. As unemployment continues to fall, we should expect to see more upward pressure on wages. Moreover, the price action in several commodity markets suggests that inflation fears should not be written off. We should also remember that some major commodities, oil is one example, are largely supplied by unstable countries such as Russia and those in the Middle East. Unfavorable supply shocks are a clear and present danger. And while the growth of health care spending has slowed in recent years, it remains higher than the rate of inflation and is likely to remain high.

Moreover, central banks are printing new money and creating new credits at unprecedented rates. If people begin to believe that governments will continue to print money to cover their intractable deficits, inflationary expectations, which today are well anchored, could spiral out of control. The “easy” solution for governments facing large fiscal deficits and substantial debt overcharges is to inflate the debt away.  We did this in the United States after World War II.  Inflation is an indirect method of defaulting on one’s debt. As long as our fiscal trajectory is unsustainable, it would be foolhardy to dismiss the threat of inflation.

The Right Way for Investors to Plan for the Possibility of Inflation

How should investors position their portfolios to guard against the possibility that the inflation rate could rise over the long term? At Wealthfront we believe that broad diversification is essential to build portfolios that will work in all seasons. And we pay particular attention to including financial and real assets that can be expected to benefit if price increases begin to accelerate.

Common stocks have proved themselves to be reliable inflation hedges. While a spike in inflation is likely to result in short-term price declines, equity returns have more than outdistanced inflation over the longer run. And certain types of stocks that are well represented in the Wealthfront portfolios are particularly effective in protecting investors. Real Estate Investment Trusts (REITs, which we only use in retirement accounts due to their poor tax efficiency) represent ownership interests in office buildings, apartment houses, and shopping malls — all real assets whose prices rise with overall inflation. Dividend growth stocks (which we use as partial substitutes for what otherwise would be a government bond market portfolio) also tend to enjoy rising prices and dividends over time as the general price level increases.

Wealthfront portfolios also include exposure to Natural Resources. As the prices of energy, materials, and agricultural products rise during periods of inflation, investors can expect this part of their portfolio to reflect those increases. Also included are Treasury Inflation Protected Securities (TIPS), inflation-indexed bonds issued by the U.S. Treasury. For TIPS, the interest paid and the face value of the bond are periodically reset based on the movements in the Consumer Price Index.

As Always, Diversify.

There are no certainties in the investment world. But a broadly diversified portfolio, including asset classes designed to increase with a rise in the overall price level, has the best chance of delivering generous returns and risk control in all economic environments.