Davidson Investment Advisors
Though measures of inflation remain low by historical standards, and below the 2% long-term target set by the Federal Reserve, markets and financial commentators seem to be turning their attention to the idea that it may soon escalate. This expectation is reflected in the sharp rise in long-term interest rates we observed last week, with the 10-year U.S. Treasury yield rising above 1.6% briefly, its highest level in over a year.
It is worth noting that a 2-3% level of inflation is considered normal, and many even consider this healthy for markets. However, the presence of higher-than-normal inflation could represent a headwind to potential returns not experienced in quite some time. With that, this piece will describe what inflation is, why it is becoming more topical, and what it may mean for investors.
What is inflation?
Inflation, defined here as the general rise in prices for goods and services and fall in the purchasing power of currency, is driven by a number of factors: economic growth, input costs, supply and demand imbalances, broad changes in wages, and general availability of money in the economy. Ironically though, one of the biggest drivers of inflation is markets’ expectations for inflation. In other words, if markets expect the purchasing power of their assets today to fall over time, they are more likely to spend those assets today at relatively lower prices, thereby causing demand for goods and services to increase and prices to rise. For example, if an individual is looking to purchase a home and expects its cost to be substantially higher in a few years, they would be more likely to purchase it today. If a large number of potential homebuyers begin to act the same way and seek to purchase sooner than later, a greater demand for housing would result in the rising prices of homes for sale, resulting in inflation of home values — a self-fulfilling prophecy, if you will.
So why the sudden attention to this topic?
In response to broad economic shutdowns and restrictions related to COVID-19, both monetary and fiscal stimulus were pumped into the economy to fill the hole left by a massive collapse in demand and to aid in a quick recovery. With so many dollars available (and so much government debt issued to fund these measures), many expect that an increased supply of money chasing after a relatively stable (or even somewhat lower) amount of goods will result in the prices of those goods rising. The catalyst for this recent expectation appears to be the likely passage of a $1.9 trillion fiscal stimulus bill. For context, this is almost 2.5 times as large as the $800 billion stimulus passed in response to the financial crisis of ’08 and ’09, and would take government spending over the last year to approximately $7 trillion. For reference, recent “normal” annual government spending is roughly $2 trillion. Such massive levels of spending is being funded largely by debt issued by the federal government, which itself is associated with rising inflation.
Importantly, lenders of money expect compensation from borrowers for their loans in the form of interest payments. Interest rates, the driver of interest payments, are best described as the cost a lender charges the borrower of their assets, and is determined by adding the expected rate of inflation with the risk premium they determine necessary to offset the possibility of default by the borrower. If lenders expect the value of their money to decrease over time though inflation, they will charge more interest on those loans to compensate for the declining purchasing power of the initial loan. In the bond market, we saw this happen last week as investors demanded higher compensation for loaning the government money, resulting in a broad rising of longer-term interest rates.
What does this mean for investors?
In fixed income, inflation results in a lower real value for the interest investors receive on their bonds. For example, if a bond was purchased in a zero inflation environment at an interest rate of 2% and inflation increases to 1.5%, the real return of that interest payment decreases to 0.5%. In such an environment, fixed income investors demand higher interest on bonds by paying lower prices for them. For existing bondholders, this could mean falling prices for issues in their portfolio. However, it also provides new bond investors to achieve higher nominal rates of returns in their portfolios when purchasing in a higher interest rate environment. In fact, a return to a marginally higher level of interest rates in the fixed income markets could benefit investors broadly, as it represents a relatively safer asset class for investors seeking income and protection of principal than markets such as equities (where many investors have turned seeking income in their portfolio in the current low rate environment in fixed income).
For equities, inflation may increase the cost of input prices such as materials or labor, resulting in the need to raise prices and consumers being able to purchase less of a given good. Inflation also increases the borrowing costs for companies, which tends to have a negative effect on highly-levered businesses and those trading at higher valuations. Conversely, companies can largely expect to increase prices in a period of inflation, which can benefit profitability and shareholder returns.
To us, inflation represents an opportunity for active investors to exercise judgement in selecting securities in companies and entities that stand to benefit from rising prices in the economy and higher interest rates. We also believe that some inflation in the economy is healthy, as it both reduces the risk of deflation (falling prices and falling earnings) and allows companies to adjust prices upward over time.
We believe in taking a long-term approach and selecting companies with resilient business models, strong balance sheets that allow them access to capital at reasonable costs, and growing revenues from business operations. We also believe that investing in individual bonds of staggered maturities makes sense in periods of rising interest rates and inflation, as the option to hold bonds to maturity allows investors to recoup par value and reinvest the proceeds of maturities at higher rates over time, if available. While we have not seen meaningful inflation in quite some time, it is also not a new concept; it is important to consider the implications of such changes to your investing objectives, but we also caution against overreaction.
Davidson Investment Advisors is a SEC registered investment advisor. The opinions expressed herein are those of Davidson Investment Advisors and are subject to change. The information contained in this presentation has been taken from trade and statistical services and other sources, which we believe to be reliable. We do not guarantee that this information is accurate or complete and it should not be relied upon as such. This presentation is for informational and illustrative purposes only, and is not intended to meet the objectives or requirements of any specific individual or account. Past performance is not an indicator of future results. An investor should assess his/her own investment needs based on his/her own financial circumstances and investment objectives.