Everyone has noticed it—at the grocery store, at the gas pump, on items from airline tickets to morning cups of coffee. Prices have risen, sharply and painfully in many cases. Inflation is the year’s big financial story. How did we get here? What is the impact on our investments? And, perhaps most important, how do we cope with it?
Inflation generally results when the volume of money and available credit increases relative to goods and services available—in other words, too much money is chasing too few goods. As a result, prices increase. The most broadly used measure of inflation is the Consumer Price Index, which measures the change in prices consumers pay for items including shelter, food, medical care, and transportation.
To understand where we are today, we need to rewind the clock. For the thirty-year period beginning 1991 and ending 2020, the annual rate of inflation as measured by the Consumer Price Index (CPI) was lower on average than its longer-term 108-year average of 3.1%. Over this thirty-year period, we saw steady or falling interest rates, as the money supply and available goods and services remained in balance. Economic growth was slow to moderate. These conditions—low inflation, low and falling interest rates and a growing economy—created generally favorable conditions for consumers, businesses, and investors.
COVID-19 brought big changes. To offset the loss of economic activity resulting from the economic shutdown associated with the virus, both the Federal Reserve and Congress injected unprecedented stimulus into the economy. The Fed took immediate action to lower interest rates. It did this by lowering the Fed Funds rate (the interest rate at which banks are able to borrow or lend to one another overnight) to virtually zero. In addition, it bought trillions of dollars of bonds in the open market in an effort to both stabilize the plummeting prices of bonds and also to pump cash into the economy.
For its part, Congress authorized by means of legislation the spending of additional trillions of dollars. Through stimulus checks for most Americans, loan programs for corporations and non-profits, cash grants to other organizations, extended unemployment payments, and many other means, the fiscal stimulus quickly made its way into the pockets and bank accounts of individuals, corporations, and institutions.
It’s no secret that opinions differ dramatically about these actions and many more actions of our leaders related to COVID-19. We’ll stick to inflation here. We’ll never know what would have happened had the Fed and Congress not provided the monetary and fiscal stimulus they did. We do know that the massive amounts of stimulus contributed to inflationary pressures when the economy reopened. Powerful, pent-up demand ran into woefully inadequate supply. The supply and demand imbalance showed up immediately; by December of 2020 the annual inflation rate was 7.04% and throughout 2021, it showed no sign of abating.
This year we felt the second half of the one-two punch, as availability of goods and services was hit by a combination of factors: the Russia/Ukraine war and continuing COVID effects that caused supply-chain bottlenecks resulting in food, labor, and energy shortages. In August, the inflation index was up 8.3% versus the previous year.
So where do we go from here? The Fed has embarked on an aggressive plan to slow the economy by raising the cost of borrowing. Its actions are basically to reverse the actions of 2020, including raising interest rates and reducing the amount of bonds it holds on its balance sheet, soaking up excess liquidity in the process. Since March, the Fed has raised interest rates five times so far, for a total of three percentage points. As interest rates rise, the cost of borrowing does too, and the economy starts to slow down. Historically, this approach is likely to work, though it takes some time to take effect.
There are some signs it’s working. A great example is the housing market. As the Fed has raised rates, the thirty-year mortgage rate has climbed to its highest since October 2008, currently surpassing 6%. Purchasing a home for $400,000, with a 20% down payment and a thirty-year fixed mortgage today versus a year ago would result in an extra $7,800 yearly expense for the buyer. As a result, the housing market has started to cool off. Homes are on the market longer, and there have been more price drops in listing values.
If we look at history, there are two critical takeaways: first, we will recover but second, it will take some time. On January 1, 1980, the inflation rate was 13.54%, and it took three years to bring it down to 3.21%. Moreover, during that time period, the U.S. had two recessions. Sobering, yes, but we did recover.
As consumers, we see the impact of inflation on our daily purchases, but what about our investments? The current spike in the inflation rate does have an effect on our stock and bond holdings.
Stock prices are down more than 20% this year, but why? Much of the answer is rising interest rates. One way a stock is valued is based on the earnings and cash flow the company expects in the future, discounted to reach its present value. Higher interest rates mean a higher cost of funds for a company, and can also signal other difficulties, such as possibly lower demand for its products—all of which will affect future cash flows. Thus, the present value of its shares falls. A good example occurred in August, when the inflation rate report was higher than expected. When the news broke, the market assumed interest rates would go higher and priced those in, as well as uncertainty about how high those rates might go. As a result, the S&P 500 dropped 4.32% in one day.
Inflation, and the higher interest rates used to combat it, have an even more direct impact on bonds. The U.S. bond market is down more than 14% year-to-date. Why does inflation lower the value of bonds? Here’s an example: Let’s say I purchased a bond in March 2020 that was paying an interest rate of 0.25%. If I wanted to sell that bond today before it matured, I would have to sell it for a lower price than I paid for it. Why would someone want to buy my bond with a 0.25% interest rate when they can buy a bond paying 3.25% interest? As interest rates rise, the value of existing bonds paying lower interest rates decreases. The good news for investors is that bonds issued today are paying out higher interest.
So how do we protect ourselves against inflation? My father and mother recently retired and relocated to South Carolina. I asked my dad what his daily routine looks like now. He told me he watches CNBC every morning. This station does a fantastic job of making the markets look as electric as the Super Bowl. His newfound hobby of listening to the “experts” on CNBC also explains his weekly texts and voicemails with investment questions I’ve been receiving. Some examples: Should I buy gold, commodities, alternative investments, a guaranteed annuity, or dividend-paying stocks? My response is always the same: “Call your investment advisor. That’s why you pay him.” It’s the advisor’s job to worry about your allocation and develop a drawdown plan for your retirement that works in good times and bad.
My father has asked me how long inflation would last and how low the market may go. If I knew the answers, I would be enjoying life on beach somewhere. Regarding inflation, I repeated one of my father’s favorite pieces of advice back to him: “You can’t always get what you want, but if you try sometimes, well you just might find you get what you need.” While we are both Rolling Stones fans, I dreaded receiving this advice from him when I was young, despite its wisdom and logic. We can’t see into the future. The best we can hope for is that using its interest rate tool the Fed can get inflation under control quickly without too much economic harm. Higher interest rates are certainly not what we want, but they may be what we need.
Here at Bragg Financial, we feel one of our strengths is humility. We don’t pretend to know what the market will do, how the Fed will act, or what else might happen to affect the markets positively or negatively. We manage portfolios using a disciplined, unemotional, and repeatable process. We take a long-term view of stocks and invest in companies that can weather market turmoil.
I recently watched a documentary called Intelligent Trees. It described how young trees will reach for the sunlight at all costs, even by growing sideways. However, those trees are the most likely to fall when the storms come. It reminded me of how the hot stocks of 2020, like Peloton, Zoom, Netflix, and ARK ETFs, shot up over 300% that year. Today they have lost significant amounts of those gains.
Conversely, the trees that grew slower grew straighter, and when the storms came, these trees did not fall. In fact, after the storm, they were able to continue to grow with less competition. At Bragg, the companies we invest in are not the companies chasing growth at all costs. The companies we buy have consistently positive earnings, strong balance sheets, and quality management. These companies have weathered storms such as the dot-com bubble, the Great Recession of 2008, and COVID. We think they have the best chance of weathering this current environment.
We all want to get inflation under control and avoid recession; however, that may take some time. But a long-term investment strategy will pay off as the market will eventually rebound and capitalism does its job. The higher interest rates of 2022 may not be what we want, but they may be what we need. We are here to provide you with sound financial advice and prudent investment management to help you and your family weather current and future storms.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.