Inflation’s Impact on Your Portfolio

Inflation rate in April 1980 peaked at 14.7%! Some of you may remember the 1970s and 1980s when inflation seemed like it was out of control. Are we headed back to these levels?

Rising inflation concerns have been dominating news headlines recently as inflation data has come in higher than expected over the past several months. This rising inflation is largely due to factors resulting from the COVID-19 pandemic, such as the recent economic stimulus and supply chain disruptions.

Although it is too soon to tell if we will return to those double-digit inflation numbers, in the long run, it’s helpful to review what inflation is exactly and what impact it could have on your portfolio.

What is Inflation?

In general, inflation is the rise of average prices for goods and services across an economy. As these prices rise, it lowers a consumer’s purchasing power. This means you cannot buy as much of a good, with the same amount of money, as you could before.

For example, you could buy a pair of sunglasses in April 2001 for $66.24. Twenty years later, April 2021, that same pair would cost $100.00. This is inflation!

Consumer Price Index

What is the current inflation rate? The U.S. Bureau of Labor Statistics (BLS) releases inflation numbers monthly through a measure called the Consumer Price Index (CPI). CPI measures the change in the prices of goods and services contained in a basket of consumer items. This is also called Headline CPI.

CPI increased 5.0% from May 2020 to May 2021, with the last month of that time period, April 2021 to May 2021, increasing 0.6%. If CPI would continue to increase each month by 0.6%, the annual inflation would be 7.2%! We are definitely trending toward higher inflation.

The U.S. BLS also releases Core CPI monthly. Core CPI is measured like Headline CPI, but it excludes food and energy. Core CPI increased 3.8% from May 2020 to May 2021 and 0.7% from April 2021 to May 2021.

Inflation Isn’t All Bad

Inflation may sound like it would harm the economy; however, most economists would agree that moderate inflation is a good thing. The Federal Reserve typically targets an inflation rate of about 2% per year.

Moderate inflation is a sign of a healthy economy and encourages consumers to buy now, assuming that goods will cost more in the future. Moderate inflation is also considered positive because it removes the risk of deflation. (Deflation is the opposite of inflation, prices fall rather than rise, and that can negatively impact the economy overall.) Why buy something right now when it could be cheaper later?

What Does it Mean for Your Portfolio?

Inflation will affect areas of your portfolio differently.

• Cash – Any cash that you hold in your portfolio will be negatively affected as the purchasing power of that cash will decrease. If interest rates are increased due to inflation, finding the best yields for your cash to keep up will be important.
  
  
• Fixed Income (Bonds) – Current bond prices will likely fall with rising inflation. Since the interest payment for a bond is typically fixed, the purchasing power of that interest payment will decrease as inflation rises. Thus, existing bonds will become less attractive. Conversely, newly issued bonds will have to pay a higher interest rate to remain competitive so that investors will purchase them.
  
  
• Equities – Stock market performance during times of inflation is largely inconclusive because of the numerous variables that play a role, such as the timing of the economic cycle. In theory, companies should see increasing revenues with higher prices as inflation increases. In contrast, inflation will also increase the cost of capital as well as materials and labor required to do business.
  
  
• Commodities and Real Assets – While not guaranteed, prices of these investments, such as gold, silver, and land, tend to increase as inflation rises.

Summary

Inflation is a complicated topic that economists have debated for centuries. Some say the current increase in inflation could be temporary as the economy recovers from the COVID-19 pandemic. However, it is too early to tell.

While the Federal Reserve has indicated that it will begin to increase interest rates, if necessary, to combat high inflation, its ability to do so without negatively impacting the stock market is unclear.

It is important to have a financial plan in place to combat economic events such as rising inflation. You should speak with a financial advisor if you are unsure how your portfolio is positioned to perform during inflationary periods.

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