Note from the CIO: Inflation Strikes Back (Again)

In the first half of 2022 we saw the overall prices of the 500 largest companies in the United States (known as the S&P 500 stock index) drop 23.6%[1]. In brief, the market appears to have priced in the likelihood of a recession that could result from the Federal Reserve raising interest rates in an effort to contain inflation. One of the main drivers of inflation has been surging energy prices, which have risen 41.6% year-over-year through the end of June.  Let’s try to make some sense of all this.

Energy fuels all other industries. It provides the heat for industrial processes, including the manufacturing of fertilizers; it refrigerates our food, transports the goods we seek, and provides the petroleum from which key vehicle parts (such as tires) are made. It is no surprise, as shown below, that many individual expenditure categories are seeing double-digit price inflation with overall inflation reaching a 40-year high of 9.1%:

One-Year inflation rate by expenditure, June 2022

Source: U.S. Bureau of Labor Statistics

This period of inflation is a global problem, with the European Union, United Kingdom, and Canada seeing similar levels of price increases over the past year. So, what causes prices to inflate? Price inflation results from an imbalance between the supply and demand of goods, where either too much demand for a good, or not enough supply of the good, or both as in the current case, can push prices higher.

On the demand side, more people are traveling and buying big-ticket items that typically require in-store visits, which are finally possible after the end of the pandemic-induced lockdowns. Additionally, there was $5 trillion of stimulus pumped into a $21 trillion economy (essentially a 25% cash bump in incomes) by the Trump and Biden administrations to help offset the financial consequences of the lockdowns. Keep in mind that the Federal Reserve was already lowering rates during the second half of 2019 just when the labor market and stock market were soaring. With rates cut to zero at the beginning of the pandemic, we never saw negative year-over-year inflation (known as “deflation”) as would logically be expected during an economic lockdown (May of 2020 year-over-year inflation dropped to 0.1%). The fact that there was no overall decrease in prices when so many people were locked down is pretty good evidence that there was a bit too much money sloshing around out there a bit too long. Not a good situation.

On the supply side, we saw fossil fuel companies, which supply 80% of the world’s energy, reduce investments in exploration and production levels, out of fear of regulatory hurdles impacting returns. In cases where regulations have been eased, a challenge has been the long ramp-up times required by the significant amount of planning inherent in the capital-intensive nature of the oil and gas industry. And when it rains, it pours: Russia’s horrific invasion of Ukraine five months ago has further strained global oil and natural gas supplies, leaving European countries such as Germany, which rely on Russia for natural gas, in a dire situation as they scramble to build up energy supplies for the winter. It also directly impacted the world’s supply of fertilizer (for which Russia is the world’s largest exporter) and wheat (for which Russia and Ukraine account for nearly a third of the global supply). Again, not a good situation.

The imbalance between the demand and supply of energy and other key commodities has created a perfect storm in those markets with unstable equilibriums resulting in run-away prices.

So how does the current inflation compare to the past 50 years? As the following chart illustrates, clearly, we are in a standout situation at the moment, but not at the level of the 1970s.

50-year History of Inflation

Source: U.S. Bureau of Labor Statistics

History may not repeat, but it rhymes. In particular, the most likely path forward will be to constrain demand, which has already begun. The Federal Reserve is attempting to slow down our demand for goods by raising interest rates and contracting the supply of money out of the system. This will make it harder for people to afford loans to buy cars and homes, and more difficult for businesses to finance operations and invest in new projects, which in turn will slow hiring and even lead to layoffs. Many are convinced a recession is inevitable, if not already under way. Since 1945, there have been nine times when the inflation rate spiked above 5%, and every one of those inflationary spikes was followed by a recession. In my opinion, the drop in stocks this year was the market pricing in this distinct possibility. Ultimately, however, the disease (inflation) is worse than the cure (recession). The good news is if history is any guide, increasing interest rates sufficiently should lead to inflation dropping just as fast as it rose.

There is another lesson from the 1970s that answers why we see two inflation spikes during that period in the previous chart. As the first inflation spike (which resulted from the oil embargo of 1973-1974) began to reverse, a recession had begun. This gave the Federal Reserve cold feet, causing them to lower interest rates too much and too fast, which led to the second inflation spike (see “Inflation Strikes Back” in the chart). Ultimately in the early 1980s, Fed Chairman Paul Volcker assertively held interest rates high enough for long enough (see “Return of the Fed” in the chart).  As a result, inflation was finally crushed in the early 1980s once and for all -- until now.

Thus, we have a formula for dealing with inflation, and now it is a matter of execution. As of mid-year, the market is forecasting that the Federal Reserve will raise interest rates by another 2.25% over the next two years, and that inflation will average 2.6% per year over the next five years.

When inflation was at last tamed in the early 1980s, the S&P 500 shot up over 25% (dividends included) in less than two months, fully recovering its value from the recent bear market. This reminds us that the worst thing one can do is to sell investments in panic during a bear market. In fact, the bear market of that period was a quintessential example of the “golden rule” of stock investing: we have to go through significant downturns on occasion (which have always been temporary), and we have to ride out every last bit of those drops, in order to capture fully all of the premium returns that propel our wealth to the next level.

We fully acknowledge that at times this can feel easier said than done. In fact, research in behavioral economics shows that the pain of losses affects us twice as much as the joy felt from gains, and the longer you are underwater in the market the more painful the experience can be. That pain can often lead to mistakes by selling at the worst possible moment, but there are no short cuts to the “golden rule”, or at least none that I have found that work. If there were a way to figure out how to get out of the market in time before a drop and to get back in at the right time before the recovery, then our investment committee would stand a pretty good chance of figuring it out. For now (and I strongly suspect, for the rest of our lives), I believe it is best for us to stick to the golden rule.

We are in this together, and fortunately your advisor has a financial plan for you that includes periods of poor returns. Therefore, we just keep working our plans, which is how we will ride out the current unpleasantness, however long it takes and whatever direction the market heads. In fact, with recent declines in stock prices by nearly a quarter, the opportunities are enhanced for long-term, goal-focused investors such as we are, making this a wise time to rebalance, harvest losses for tax reduction, and deploy surplus cash. 

Thank you for your continued confidence in what we are doing. I’m more convinced than ever that we’re following the right strategy, and our team is always here when you need us. 

[1] The drop was from the market’s all-time high on January 3 through the lowest point so far as of this writing, which was set on June 16. A drop of 20% or more is commonly referred to as a “bear market”.

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