INFLATION RISK
Inflation is too much money chasing too few things. Inflation results in the decline of purchasing power of a currency over time and measures the rate which the value of a currency is falling or being debased.
The Federal Reserve has a stated target of 2.0% inflation……which means the dollar will be worth 50% less over 35 years if the target is achieved.
Recently, inflation has been less than the target, which proves the Federal Reserve is unable to control inflation. And since inflation has recently been less than the target….. inflation may exceed the target for an extended period as well.
Most investment returns are expressed as gross returns but returns should be judged in real returns or after the effects of inflation. The primary risk inflation is achieving investment returns less than long-term inflation.
An entire generation of investors (and speculators) have not had to experience meaningful inflation but investors should be prepared for inflation risk which will lower gross and real returns.
INFLATION: HISTORICAL PERSPECTIVE
Since 1950, inflation (as measured by the Consumer Price Index) has averaged 3.5%. On a cumulative basis, the CPI Index has increased from 25 to 261 representing more than a 10-fold increase in 70 years. This debasement of the dollar means that what used to cost $1 now costs approximately $10.
In the first 40 years (1950-1990), inflation averaged 4.3% but in the last 30 years (1990-2020), inflation only averaged 2.3%. The last 30 years have been a wonderful period of price stability and declining interest rates which both have contributed to “better than average” returns.
ASSET CLASS IMPLICATIONS:
BONDS
For the bond investor, inflationary impacts are easy to see. When the value of the dollar deteriorates with time, the security with income and principal payments denominated in dollars will be worth less. To illustrate, a 10-year treasury yielding 1.5% cannot provide a real return if inflation is 2.0%, resulting in a negative real yield. The holder of the 10-year treasury will have less purchasing power as a result of the “investment”. The stated coupon and ensuing payment will erode quickest over time during periods of rising or higher inflation.
(Conversely, for the issuer of debt, inflation helps reduce liabilities as debts are repaid with cheaper dollars.)
STOCKS
Stocks or equities have the potential to better protect against inflationary forces. There are 5 economic levers that can increase the economic output of a business. Increasing sales relative to assets, wider operating margins, more leverage, cheaper leverage and lower taxes. And inflationary forces has the potential to negatively impact all 5 levers.
What reduces inflation risk? Several characteristics of business and business models can counteract the deterioration of economics caused by inflation. Companies with pricing power and the ability to increase prices at or above rates of input cost will offer inflation protection. In addition, companies that are asset-light. Asset-light companies have fewer capital expenditures and depreciation, which are the worst forms of expense since money is spent first, then the item is expensed via depreciation over its useful life and then the item is replaced at a substantially higher cost.
CONCLUSION:
History teaches us that politicians, economists, policymakers, or business leaders can guarantee the world will maintain low and stable rates of inflation and inflation can arrive with little warning. Using the definition of too much money chasing too few things…..there is ample evidence that inflation may increase. But there are several ways to protect against higher inflation.
