The Inflation Threat
A central motive for investing is to avoid holding cash, whose value is eroded by inflation. While stocks have often been an excellent way to guard against inflation, high inflation can prove a challenge to building wealth. Inflation is again on the upsurge, and we want to take a minute to look at what inflation has meant to stock investors over time.
Consider last week’s eye-catching data. Headline inflation in May rose to 8.6% from 8.3% on a year-over-year basis, reaching a four-decade high. Surging energy and food prices led the way. Economists were expecting a rise of 8.3%. This reported increase masks the even larger spike measured from quarter to quarter. On this basis, the 3-month annualized inflation rate rose to 10.7% from 9.9%.
Stock Investing and Inflation
Inflation represents the rate of erosion of the real value of an investment over time. Inflation also proxies the return investments need to maintain your standard of living. It occurs when too much money chases the volume of economic goods and services. When investment returns fail to pace inflation, wealth declines in a real sense. The investment wealth generated cannot buy the now higher-priced goods and services. In real terms, buying the same level of goods and services costs more. Thus, you, as the investor, are losing ground. If inflation is moderate and short-lived, the impact can be manageable. The effect can be hard to manage if inflation is high or carries on for many years.
Consider the last several decades. Table 1 highlights the damage that inflation does to investment returns. When returns are low and inflation high, positive stock returns can translate into negative real returns. In particular, look at the decade of the 1970s.
Table 1
U.S. Equity Returns by Decade
| Before Inflation (Nominal) | After Inflation (Real) | |
| 2010s | 13.6% | 11.6% |
| 2000s | -0.1% | -3.3% |
| 1990s | 18.2% | 14.8% |
| 1980s | 17.6% | 11.9% |
| 1970s | 5.9% | -1.4% |
| 1960s | 7.8% | 5.2% |
| 1950s | 19.4% | 16.8% |
| 1940s | 9.2% | 3.6% |
| Source: Bloomberg, WCA |
In the long run, nominal returns tend to obscure short-term trends in real returns. Investors with long time horizons should generally remain fully invested. This is especially true if inflation tends to revert to its long-run average level. But, if inflation persists and the economy weakens, personal consumption may need to be cut, and personal savings may need to increase if households are to meet future goals.
Policymakers’ New Job
The Federal Reserve (Fed) now has to play catch-up to neutralize inflation. The tools they will use to try and do this are interest rates and their balance sheet. They will rapidly increase interest rates and reduce holdings of assets. These actions are commonly referred to as monetary “tightening.”
The current Fed Funds rate is 1%. Yet, the market is currently pricing in three rate hikes of 50 basis points each. This would bring the rate to 2.50% with more Fed tightening. With inflation running close to double digits, rates may need to go even higher. Whether or not more hikes are needed will depend on how inflation proceeds from here and how well the economy and markets hold up as the Fed tightens.
Prosperity Needs Low and Steady Inflation
We hope, of course, that the Fed successfully engineers a slowdown in the rate of inflation. Yet, the Fed got it wrong when they claimed more than a year ago that the inflation spike was transitory. Ongoing supply and demand imbalances and political turmoil suggest we have not yet seen the end of inflation. Low and steady inflation allows businesses and households to plan and invest, while high and uneven inflation undermines confidence.
Allowing inflation to continue and to undermine confidence would be a disaster, and policymakers know it. Moreover, inflation tends to hurt those at the bottom of the economic ladder more than those at the top. Consequently, “reining in inflation” should remain policymakers’ number one job. We expect policymakers to err on the side of too much, not too little, action.
Conclusion
In conclusion, despite inflationary spikes, we continue to buy high-quality stocks. We see owning flexible, durable, and predictable businesses, trading at reasonable valuations, as a sound way to navigate the challenges of inflation.
Disclosures:
WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.
S&P Global (SPGI) is a leading American provider of financial information, analytics, and credit ratings, headquartered in New York, NY. It operates major divisions including S&P Global Ratings, S&P Global Market Intelligence, S&P Global Commodity Insights, S&P Global Mobility, and S&P Dow Jones Indices.
The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.
The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.
The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price.
The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.
The WCA Rising Dividend Custom Benchmark is a rules-based benchmark constructed by Washington Crossing Advisors to represent a universe of large capitalization U.S. companies that meet certain quality and dividend growth criteria, including proprietary screens for profitability, earnings consistency, and balance sheet strength, along with minimum market capitalization and dividend growth requirements. The benchmark is reconstituted and rebalanced quarterly and is intended to serve as a style-appropriate benchmark for the WCA Rising Dividend strategy.
The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.
The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
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All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio relative to the market as a whole. A beta of one is considered as risky as the benchmark and is therefore likely to provide expected returns approximate to those of the benchmark during both up and down periods. A portfolio with a beta of two would move approximately twice as much as the benchmark.
Standard deviation is a measure of the volatility of a security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.
Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments
This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.
The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.
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