Over the prior several months inflation fears have been stoked by high Consumer Price Index (CPI) figures. For instance, in July CPI jumped 0.5% over the 1-month period, pushing the 12-month figure to 5.4%. This was the largest year-over-year increase since after the Global Financial Crisis in 2008. Inflation has certainly been on the mind of the Federal Reserve (the Fed) as well. It has been one of their predominant narratives – along with unemployment, which has garnered attention in the financial news. The consensus has been that inflation is transitory, which means a higher level of inflation may persist for some time as the world reopens and supply channels catch up to the high levels of demand. This in combination with expansionary monetary policy and continued fiscal stimulus, most recently in the form of the infrastructure bill, has led to increasing prices in many segments of the market. While we do not believe that inflation will reach levels seen in the 1970’s, we do see inflation rising moderately due to supply chain disruptions caused by COVID-related lockdowns as well as the expansionary monetary and fiscal policy. What we hope to highlight in this note are ways in which your Private Ocean portfolio is hedged against moderate levels of inflation and why there shouldn’t be cause for great concern.
Several segments of the Consumer Price Index stood out as contributors to larger CPI figures. Used-vehicle prices rose only 0.2% in July but had previously jumped 10.5% in June and 7.3% in May. Past gains in used-vehicle prices were attributed to lean inventories. New-vehicle prices were up 1.7% after rising 2% in June, with some issues stemming from chip shortages in Asia due to COVID-related supply chain disruptions. Energy prices increased 1.6% while food prices were up 0.7%. Excluding food and energy, the CPI rose 0.3%, a touch weaker than the consensus expected. As seen below, the Consumer Price Index remains elevated, but has decelerated month-over-month. Major contributors include Shelter (housing costs), which has seen limited supply and a huge surge in demand due to low interest rates and the migration out of cities, Energy, and New Vehicles.
These issues stem from COVID-19 and the related economic shutdowns, which have caused some extensive issues on both the supply side and the demand side of the equation. Let’s start on the supply side: producers have seen prices increase, including energy, labor, and materials. This has caused what is known as cost-push inflation, or inflation driven by the primary components of finished goods, which applies pressure to manufacturers and others that make and sell finished goods. This price increase on resilient businesses with pricing power can be passed along to consumers, but not always. An example of a business with strong pricing power held in our portfolios is Proctor & Gamble. Given the recent surge in commodity prices, they are raising prices on things like baby formula and household cleaning products. The consumer in this case bears part of that cost of inflation seen in rising commodity prices. Those businesses without pricing power must bear these price increases on their own. Some of these increases can be seen in the below chart, which highlights the Producer Price Index (PPI). The PPI captures how producer prices have fared in recent months and tracks inputs like commodities, transportation, and warehousing.
As an example of how transportation costs can heavily weigh on producers, below is a chart from the United Nations Conference of Trade and Development (UNCTAD), which highlights the large increase in prices for containerized shipping from various major global ports.
On the demand side, there has been an increase in demand by consumers due to continued fiscal spending, accommodative monetary policy, and the reopening of many global economies. Simultaneously, there have been supply chain disruptions due to the virus, which have put a strain on how much of that demand can be met. This is known as demand-pull inflation.
With these inflationary forces, we believe it is important to highlight the components of your portfolio that are best equipped to handle any inflationary concerns should they arise.
Equities have historically been great hedges during periods of moderate inflation. Meanwhile, in periods of extreme inflation, like the late 1970’s, equities are not effective as an inflation hedge. In the past, as inflation got out of hand, the Fed has typically raised interest rates rapidly to reign it in. These higher interest rates weigh on company earnings and make it more expensive to borrow and fund growth projects. However, we do not believe that this is what we are experiencing currently. If we look to the markets and how they are pricing in inflation currently (using longer term breakeven inflation rates), inflation seems relatively tame, and just above the Fed’s two percent average target, which the Fed is ok with:
While the markets are relatively efficient and tend to do a good job of pricing in inflation expectations, there have been times when inflation surprises to the upside. Even still, the market has been quick to react to this new information and those assets that act as a hedge in moderate inflation scenarios have adjusted rapidly. Global equities are a good example of this.
REITs and other Real Estate
Real estate has also been a solid hedge against inflation for two key reasons: 1) as inflation rises, the value of the property itself will typically rise as well, and 2) as inflation rises, the owner of that building (or the manager of a REIT) can pass those price increases along to tenants in the form of higher rent prices.
Inflation Protected Securities
Inflation protected securities such as Treasury Inflation Protected Securities (TIPS) as well as real return funds (like the municipal real return fund in your portfolio) are usually linked directly to inflation or use instruments to track and hedge against the risk of inflation. These securities are explicitly included in the portfolio to protect against sudden increases in inflation rates. Given the recent concerns around inflation, we have unsurprisingly seen strong returns from these assets year-to-date.
Recent inflation figures have prompted some concern; however, we believe that these figures are relatively moderate and mainly a function of the rebound from COVID-19 related lockdowns and disruptions dovetailed with expansionary fiscal and monetary policy. We do not anticipate runaway inflation to occur as was the case in the 1970s. As the global economy continues to combat the virus and reopen, we anticipate that these dislocations in the market will dissipate, and inflation will return to a more modest level. In the meantime, several components of Private Ocean portfolios look to mitigate the impact of short-term and moderate levels of inflation including global equities, REITs and inflation protected fixed income securities.
Sources: Bureau of Labor Statistics; FRED St Louis Federal Reserve; Ycharts; Moody’s Analytics
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