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The Inflationary Regime

| August 16, 2022

Recently, Consumer Price Index data showed that inflation may have finally peaked. In the short run, investors are likely to focus on the trend of inflation and hope that it continues to move lower. However, even if prices moderate, it is likely that inflation will not return to the Fed’s 2% inflation target anytime soon.

To begin, let’s consider the reasons for more sustained inflation. During the initial stages of the COVID outbreak, supply bottlenecks and low labor participation resulted in an increase in prices. This inflation was described by many as ‘transitory’ because it was assumed that supply chains would work themselves out and people would return to the workplace after they felt safer and as government assistance programs expired. As supply chain and labor issues resolved, it was hoped that the economy would return to lower inflation levels.

Since then, some supply chain issues have been fixed but many remain due to the uneven global COVID response. More importantly, as a result of the Russia-Ukraine war and other geo-political issues, supply chain safety and redundancy will likely be prioritized over supply chain efficiency. This will mean that supply chains become more local. Just as globalization was a major deflationary force over the past few decades, ‘anti-globalization’ will tend to cause higher prices.

The employment and wage environment is also generally inflationary. After COVID-related government relief programs rolled off, worker shortages remained and deepened. As Goldman Sachs strategist Jan Hatzius recently mentioned: “We still have close to 11 million open positions and less than 6 million unemployed workers. That’s still a very large gap, basically unprecedented, both in absolute terms and relative to the size of the population in post-war history.” Given this employment environment, workers are likely to be able to continue to command better wages. Higher wages are a key and relatively resilient source of inflation.

Lastly, a less appreciated aspect to the current situation is the way in which COVID intensified underinvestment in several areas. A lack of infrastructure and energy spending is contributing to the inflation problem as chronic underinvestment has led to supply shortages.

There is, of course, the hope that the Fed will kill inflation by slowing economic expansion, but the Fed is unlikely to be completely successful due to the nature of the forces describe above. Supply chains will likely be less stressed if growth moderates, but growth would have to completely fall off a cliff for more than 5 million jobs to evaporate. Additionally, the last inflationary source listed above – underinvestment in key sectors – will likely get worse as the Fed raises rates. Tighter financial conditions caused by Fed rate hikes may reduce investment in infrastructure and energy, exacerbating the lack of supply and causing prices to remain stubbornly high.

For these reasons, we’d suggest that inflation will remain above the levels seen during much of the past decade. This, in turn, may result in changes to the financial landscape:

First, interest rates may remain higher. This is not a very difficult hurdle when it is considered that, according to Federal Reserve Economic Data (FRED), from 2012 through 2021, the average yield on the 10-Year Treasury Note was 2.04%. Rates and yields in the range of 2.5% to 4% are still relatively low by historic standards and shouldn’t be an impediment to economic growth. Still, higher rates and yields will be meaningful for investors.

Additionally, a regime that includes higher inflation may feature greater volatility in financial markets. The idea of the ‘Fed put’ – in which investors felt assured that any strong downturn in the equities markets would be met by accommodative Fed policy – likely needs to be shelved. Over the past decade, the Fed had the leeway to support financial markets without regard to inflationary pressures. In the current environment, that has changed. Higher inflation – particularly with respect to wages – will make earnings estimates less reliable, which may add to equity volatility. As the Fed has a more difficult job in navigating inflationary pressures and growth and employment considerations, it is likely that the Fed will be more dynamic and reactive. As a result, we would expect higher volatility in interest rate and credit markets.

So, how does this effect investor positioning…

First, some hedged equity alternatives may be attractive as higher volatility and higher interest rates both impact the pricing of these investments. For similar reasons, certain annuity features and rates may also be more appealing. Income-oriented investors may find that covered call strategies offer higher premium income.

Second, investors may want to consider real asset categories for their portfolio. The return on Treasury Inflation-Protected Securities (TIPS) is directly linked to inflation, and public or private real estate or infrastructure investments may have earnings closely tied to inflation. Like other asset groups, volatility should be expected, but long-term investors may gain diversification and performance benefits.

Last, a more significant and active fixed income allocation may be warranted. For much of the past decade, bond yields were relatively unattractive. Investors lost interest in fixed income; Over-weights to equities were justified with the acronym ‘TINA’ – There Is No Alternative (to investing in stocks). ‘TINA’ may need to join the ‘Fed put’ in retirement as bond categories may now provide a more meaningful investment opportunity.

To be clear, we expect inflation to continue to moderate. Markets will likely – over the short run – only care that the trend is favorable. Over a longer stretch, however, the factors mentioned here will bear consideration as the trough inflation level remains higher than the pre-COVID period.