With everything from used cars to building materials costing more, the Labor Department’s announcement last month that consumer prices continued their rapid ascent held little surprise to consumers.
The real debate is whether current inflation is caused by temporary conditions such as supply chain concerns, or a more long-term phenomenon due to the massive increase in monetary supply due to last year’s stimulus.
I am firmly in the latter camp. In 2020, the monetary supply increased a staggering 20%, according to Deloitte, much higher than the typical 5% to 7% rate. This year will likely be no different, as increases in government spending for everything from infrastructure to student loan forgiveness will only add to the pile of money and debt the U.S. is accumulating.
Looking at it another way, it isn’t that consumer products, housing, and other assets are more expensive. It could be that a vastly diluted dollar just won’t buy what it used to. Fortunately, there are some definite steps 401k plan participants can do as we pivot to a future of higher inflation.
Learn about real returns
Assuming the annual inflation rate of around 5% from July continues, that is the minimum return needed to keep from eroding one’s buying power. So, a fixed annuity with a 1% yield will result in a 4% loss in purchasing power. This is known as the real return.
There are two ways to play this unusual period of lower interest rates and high inflation. While some investors prefer to hold more money in cash with the expectation that investment prices will adjust to normal historical valuations, others simply step on the gas and own riskier assets. Combining both of these mindsets in a barbell approach likely makes sense for most investors.
Think global, and own the hard stuff
One potential result of the dramatic increase in the supply of greenbacks lies in its valuation relative to other currencies. As the U.S. continues printing cash faster than other developed nations, the greenback should eventually drop in value versus other currencies. That will give foreign stocks a nice headwind, as their equities will benefit from their home currency’s appreciation. As a result, developed market equities (think Europe and Asia) deserve a spot in one’s portfolio, as well as emerging market stocks, which could benefit from rising commodity prices.
Recent research from Vanguard shows that commodities themselves can be a useful tool in one’s inflation-fighting arsenal. Using a concept called “inflation beta,” Vanguard found over the last ten years that raw assets rose 7-9% for every 1% of unexpected inflation in the economy. That sort of sensitivity means that a relatively small allocation to a commodity fund can potentially reap serious benefits for 401k investors, especially during the economic periods when inflation is running at a much higher than expected clip. This is certainly the case today, and commodity funds have had a banner year,
With the Goldman Sachs Commodity Index up nearly 30% in 2021.
Rethink the glidepath
Traditional logic dictates that as plan participants get closer to retirement, their allocation to stocks is reduced. That makes sense at the portfolio level, as cutting risk close to one’s distribution phase can decrease the volatility of the participant’s nest egg as they enter retirement. But in an inflationary environment, relying too much on lower-yielding assets like fixed income can result in a loss of purchasing power. A possible solution is to continue investing in growth opportunities. Stocks appreciate as the economy grows, and inflation is a natural result of this process. As a result, those close to retirement should be open to owning a larger percentage of equities than they normally would during periods of rising inflation.
The good news about inflation is that it’s endemic of a growing (or, in this case, a rebooting) economy. It’s far better to participate in rising prices by owning stocks and commodities than by simply hoping it will go away. After all, inflation is a far better scenario than falling prices. Japan has struggled with deflation for two decades and the result has been reduced corporate profits and stagnant wage growth.
Ben Warwick is Chief Investment Officer of Denver-based Aveo Capital Management.
Ben Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm advises on assets with traditional long-only equity and fixed income, private equity, managed futures, and alternative investment mandates. Warwick is the author or editor of six books on investing, including Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000).
