Of all the fears investors have faced over the past 30 years, high inflation wasn’t among them. In 2021, that’s changed.
Today, the biggest questions for investors revolve around inflation: How high will it go and how long will it last? Is it “transitory” as the Federal Reserve claims? Or is elevated inflation the new normal amid labor shortages, supply chain bottlenecks and a severe energy crunch?
The uncertain path of the pandemic makes near-term conditions difficult to predict but, over the long term, the picture comes into better focus, says Pramod Atluri, principal investment officer of The Bond Fund of America®.
“While we are facing a cyclical rise in inflation and interest rates today, when I look out five years, I think U.S. economic growth will be slower and inflation may be lower,” Atluri says. Economic growth should slow due to high debt levels and fading stimulus, resulting in a return to GDP gains of 1.5% to 2.5% a year. Consequently, interest rates should stay relatively low as well.
“In the meantime, we are laser focused on inflation because that’s the biggest risk to investors’ portfolios over the near term,” Atluri explains. “If we are wrong about inflation, we will be wrong on the upside, so it makes sense to protect against that outcome.”
A tale of two inflations: Sticky versus flexible
Two flavors of inflation: Sticky and flexible
A source of uncertainty today is that there are two different types of inflation: sticky and flexible. Sticky inflation, currently around 2.6% annualized, tends to exhibit longer staying power. Sticky categories include rent, owners’ equivalent rent, insurance costs and medical expenses.
Flexible inflation has climbed this year to nearly 14% — the highest since the 1970s. However, this level of inflation likely won’t last. The flexible category contains products such as food, energy and cars, where prices can move a lot higher or lower over time. For instance, that’s already happened with lumber, copper and soybeans. Prices for those products skyrocketed this spring and have since come down.
Price flare-ups in key commodities are starting to level out
Beware of sticky inflation
As anyone who has tried to buy a used car knows, flexible inflation categories have spiked due to pandemic-related shortages, a lack of available labor and supply chain disruptions. A quick resolution to these challenges is unlikely, but more normal conditions should return by mid to late 2022, says Ritchie Tuazon, principal investment officer of American Funds Strategic Bond FundSM.
“What that means is, the upside risk is in the sticky components,” Tuazon explains. “Many of the flexible price categories moved higher for transitory reasons, but inflation in those areas may come back down to zero or even go negative. The sticky components will drive inflation in 2022 so that’s what investors need to keep an eye on.”
In short, flexible inflation is transitory, but sticky inflation could be troublesome.
If that prediction holds, there’s a good chance the Federal Reserve will not raise interest rates in 2022. Tuazon expects the Fed to officially announce in November that it will begin reducing its bond-buying stimulus program. That process will take several quarters. And the Fed’s first rate hike will come in 2023, which is later than market expectations.
What if this benign inflation outlook is wrong and consumer prices move sharply higher?
“That is by no means our base case, but I think it is a big enough risk that it should factor into portfolio construction,” Tuazon adds. He favors Treasury Inflation-Protected Securities, or TIPS, as an effective hedge against higher inflation.
Before making portfolio adjustments, it’s important to remember that sustained periods of elevated inflation are rare in U.S. history. People of a certain age will remember the ultra-high inflation of the 1970s and early 1980s. But in hindsight, it’s clear that was a unique period. In fact, deflationary pressures have often been more difficult to tame, as students of the Great Depression will attest.
Another important point: It’s mostly at the extremes — when inflation is 6% or above — that financial assets tend to struggle. Stocks have also come under pressure when inflation goes negative, as one would expect.
For investors, some inflation can be a good thing. Even during times of higher inflation, stocks and bonds have generally provided solid returns as shown in the chart below.
Stocks and bonds have done well in various inflation environments