What Does Inflation Mean for Equities

At the moment, inflation is probably the hottest topic when it comes to the economy. While it started to percolate last spring, the U.S. really started to see inflation heat up in the second half of 2021 and thus far, it has only continued to accelerate in 2022. January brought us the fastest annual pace of inflation since 1982, with the Consumer Price Index for All Urban Consumers (CPI-U) increasing by 7.5% for the previous 12 months. If you have tried to buy a car, been to the grocery store or the gas pump, this likely doesn’t come as a surprise. To further complicate the inflation story, the Ukraine-Russia conflict has prompted sanctions that are pouring gasoline on the inflation fire. While we can argue what the systemic causes of inflation are, and to what degree the various causes are responsible, there are a few factors that are undeniably playing a role:

Soaring energy prices. Prior to the Ukraine-Russia conflict, WTI Crude Oil had already experienced severely higher prices. Prices had increased to the mid $90s per barrel, compared to the low $40s in the summer of 2020 after prices recovered from the COVID-caused collapse. The Ukraine-Russia situation has further exasperated this trend, and with today’s news (3/8/22) of the Russian oil ban, WTI has skyrocketed to around $124 per barrel. This is the highest level for WTI since 2008 and we are now seeing record national gas prices at the pump.

Global supply chain issues and supply shortages. The supply shortages have caused issues ranging from emptier shelves in grocery stores, computer chip shortages, and worker shortages that have made it challenging for companies to hire. As of early 2022, our economy has approximately 3 million less people employed than before the pandemic began. The chip shortage has been the primary driver of higher vehicle costs, amongst other things. The new sanctions on Russia have now caused wheat prices (Russia is the world’s largest exporter) to see a major spike, up 70% the last month and at an all- time high. Naturally, this is expected to lead to even higher costs at the grocery store. These are just a few of the primary shortages that have led to big spikes in costs for various goods.

The unprecedented monetary support from The Federal Reserve and fiscal support from the federal government.
- The Fed are still at ~0% interest rates (Federal Funds Rate) and enacted a massive round of Quantitative Easing (QE) in response to COVID, amongst other actions. As a result, the Fed’s balance sheet has approximately doubled in the past two years.¹ As we mentioned in Part 2 of this 3-Part blog series, the Fed is likely to raise interest rates following their March meeting.
- Additionally, the U.S. federal government has approved approximately $4.5 Trillion in total aid spending due to COVID,² making total government spending around $13 Trillion over the last two years. This spending went to states and municipalities, forgivable loans for small businesses (with certain criteria needing to be met), enhanced unemployment benefits for those that lost jobs, direct payments to citizens, and allowed for the suspension of student loan payments and eviction moratoriums.

With nearly 40% of the M2* money supply having been created in the last two years, the government flushing additional cash into the system, and supply shortages, we have too many dollars chasing too few goods. While it remains uncertain how long inflation will persist, it likely won’t be getting better in the short run. The Fed has a very difficult task on their hands as they are about to embark on a cycle of hiking interest rates. They will be challenged with trying to control inflation without tipping the economy into recession.

With most problems, it is best to plan for inflation before it arrives. With our firm belief that equities are the superior asset class to keep pace with, and outpace inflation, our clients have handsomely grown their purchasing power over the last decade, long before inflation has kicked in.

We’ve attached a piece, Investing In Inflationary Environments by Russell Investments³, that investigates how markets have performed in high, above average, below average, and low inflationary environments from 1980 through 2021. While we encourage you to read the whole piece, here is how equities and other growth assets have performed in high (average CPI of 5.4%) & above average (average CPI of 3.2%) inflationary periods:

High Inflation:US equities have averaged 10.6% and Non-US equities up 9.9%. Specifically, commodities and REITs (Real Estate Investment Trusts), both asset classes that tend to our perform during inflation, have average returns of 14.5% and 9.9%, respectively.

Above Average Inflation: US equities show average returns of 15%, Non-US equities of 10.8%, Commodities of 11.5%, and REITs of 19%.

Final Thoughts

With equities (as measured by the S&P 500) averaging approximately 14% annually the last decade (including YTD declines), equity investors have meaningfully outpaced inflation. Inflation may claw back a minor portion, but as we see above, strong returns for equities still tend to occur during high inflationary periods. While we expect equities to continue to be the winning approach for hedging inflation, we always want to maintain a broadly diversified portfolio. To learn more about what Traction is doing in our fixed income portfolios, please revisit Part 2 of this blog series.

Not to be overlooked is the dynamic financial planning process and our ability to stress test portfolios and financial plans for higher inflation. While we’ve historically utilized 3% as our baseline inflation rate, which has been much higher than 20-year average, we have the ability to model any rate of inflation. If you or someone you know is concerned with inflation and what it means for your financial security, we encourage you to give us a call.

*The M2 money supply is the measure of money supply that includes financial assets held mainly by households such as: savings deposits, time deposits, and balances in retail money market mutual funds. This is in addition to more readily available liquid financial assets in the M1 supply. The M1 supply includes currency, traveler’s check, demand deposits, and other checkable deposits.