IT’S OFTEN THE THINGS YOU DON’T SEE COMING THAT GET YOU
I mention this because though it didn’t get much play in the media, we just had the highest calendar quarter for inflation since late 2012. This may or may not be the start of a trend, but it is a useful reminder that the pace of price changes, ranging from deflation to inflation, can be very unstable and therefore presents a variety of risks.
Though people tend to associate investment risk with things like stock market crashes, historically inflation has been more damaging in the long run. Bear markets are disruptive, but time and time again stocks have recovered to reach new highs, often within just a few years of hitting bottom. In contrast, inflation hardly ever gives back what it has eroded from people’s purchasing power because periods of deflation have been very rare in the U.S. economy. That is why inflation has generally done more lasting damage than bear markets.
At the other extreme, if a sustained period of deflation did take hold, it would also be damaging by diminishing the value of assets and suppressing economic growth. The point is that price instability, either in the form of rapidly rising or falling prices, is a problem for investors. Part of the danger is that people may have gotten a little complacent about this because we’ve been living in a remarkable era of low inflation.
A remarkable era of low inflation
The U.S. Bureau of Labor Statistics has inflation data going back to 1947, and since that time the annual inflation rate has averaged 3.54 percent. At that rate, prices double roughly every 20 years, so someone who has built wealth by the age of 40 can reasonably expect to see the purchasing power of that wealth cut by three-quarters over the remaining course of their lifetime. This is what scares TIGER 21 Members and therefore they set up their portfolios to try to protect themselves from inflation. That is why a consistent program of productive investing is vital to avoid going backwards.
However, you have to forgive people if they don’t take inflation protection as seriously now as they did 30 years ago. It’s not just that the current economic cycle has been characterized by very low inflation. Even beyond this cycle, with an annual average rate of just 1.50 percent since the start of the Great Recession, inflation has averaged only 2.30 percent since the end of 1990, meaning that we’ve seen a quarter century of price increases well below the historical norm.
As a result, there is a whole generation of people entering their peak wealth-building years after having grown up without experiencing much in the way of inflation. This is why complacency about inflation is a serious danger. That danger can be thought of as standing on a mountain peak with sheer drops on either side ‚Äì one side is high inflation and one side is deflation, and either extreme is a real hazard to wealth and earning power.
Agents of change
This comes to mind now because there are agents of change in play that could upset the stable price environment we’ve enjoyed for the past quarter century. In what could be thought of as a shot across the bow, inflation in the second quarter of 2016 rose at what would project out to a 3.42 percent annual rate ‚Äì much closer to the long-term historical rate of inflation than what we’ve experienced over the past 25 years or during the current economic cycle. Inflation numbers can be quite erratic so it is far from a given that the second quarter rate of price increases will continue. Beyond simply extrapolating out last quarter’s inflation rate, however, there are reasons to be concerned that inflation could make a comeback.
Two things in particular have favored low inflation over the past couple years: falling oil prices and a strong dollar. Assuming these trends cannot continue forever ‚Äì and might actually reverse, as oil prices have done in recent months ‚Äì you can look at the extremely low inflation we’ve experienced as being somewhat artificial. At some point, a return towards more normal levels is inevitable. When people have become accustomed to virtually no inflation, even normal levels of inflation could be disruptive and devastating for many.
We might count the Federal Reserve among those who seem a little complacent about low inflation. For anyone who remembers the desperate struggles the Fed experienced in its fight against inflation in the early 1980s, it is pretty strange to read the way recent Fed statements have emphasized a position designed to encourage higher inflation. Reading about anyone ‚Äì and in particular the central bank ‚Äì rooting for higher inflation brings to mind the old warning: “be careful what you wish for….”
Again though, high inflation is just one potential danger. Deflation, perhaps as a consequence of a strong dollar and global economic weakness, could push the pricing environment to the other extreme. It is crucial not to make the mistake of assuming that the environment of slow and steady price increases will continue indefinitely.
It is far from the consensus that we are about to see a resurgence of inflation, but that’s part of the point. If there were a widely-held expectation of higher inflation, we would have seen bond yields pushed higher, which has not happened. Of course, that means bonds remain especially vulnerable to rising inflation.
Low yields are a manifestation of the fact that the financial markets are content with inflation remaining low, and to a risk-conscious investor, that kind of complacency is a danger. Perhaps then, the second quarter’s uptick in inflation should be a cue to review holdings for inflation exposures ‚Äì both positive and negative.
Inflation also plays a prominent role in wealth planning, as shown by the example given earlier of the decrease in purchasing power a 40-year-old can expect to see over a normal life span. In times of low inflation, it is important to resist the temptation to cut future inflation assumptions too drastically, because this creates the risk that real wealth will start to fall short of expectations.
This is less about trying to make an inflation forecast than accounting for all the possibilities. In both investment strategy and wealth planning, it is wise to do some multi-scenario testing. Think through the what-ifs, so you can understand your vulnerabilities should either high inflation or deflation take hold.
Because it is often the things you don’t see coming that get you, experienced investors and entrepreneurs develop an instinct for when to look over their shoulders to see if something is sneaking up on them. As quiet as inflation has been in recent years, it is never a good time to go to sleep on it ‚Äì especially when it might be just waking up.
Barbara GoodsteinPresident & CEO of TIGER 21