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.
Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051
Chad Morganlander
Senior Portfolio Manager
973-549-4052
Matthew Battipaglia
Portfolio Manager
973-549-4047
Steve Lerit, CFA
Senior Risk Manager
973-549-4028
Tom Serzan
Analyst
973-549-4335
Suzanne Ashley
Internal Relationship Manager
973-549-4168
Eric Needham
Director, External Sales and Marketing
312-771-6010
Jeffrey Battipaglia
Client Portfolio Manager
973-549-4031
Disclosures
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.
Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. 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. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. 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. 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.
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.
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.
Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.
Disclosures
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.
Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. 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. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. 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. 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.
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.
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.
Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.
