Inflation is rising. How might that impact your investments?
If you don’t see inflation as much of a threat, you’re probably under 40 years old.
Either that or you suspect the recent trend of rising prices for houses, rent, food, commodities, gasoline, cars and labor will prove to be fleeting.
The trend could be temporary or even beneficial. It wasn’t long ago that experts were worried about deflation, a more serious threat that slows down economic activity.
But too much inflation too quickly isn’t good, either. “What’s clear about inflation is, once that plane takes off on the runway, it’s pretty hard to turn it around,” quipped Sarah Foster, a writer at Bankrate.com.
Older Americans know an inflationary surge can be hard to reverse. They remember the gasoline lines of the 1970s, shoppers jostling over groceries and other anecdotes from the nation’s worst economic decade since World War II.
The current inflationary climate still isn’t anywhere near where it was back then, but it doesn’t hurt to consider the possibilities, especially the possible impact on investments.
Do investments fare poorly amid inflation?
Not necessarily, though it largely depends on the investment in question and the circumstances. During the rough 1970s, large stocks such as those in the Standard & Poor’s 500 index averaged subpar returns of 5.9% annually, but small stocks did nearly twice as well, up 11.5% on average, according to researcher Morningstar.
When inflation ebbed in the 1980s, stock investments surged, averaging double-digit returns (including dividends) across the board.
Gold is widely considered to be an excellent hedge or store of value during inflationary periods, yet prices have weakened lately despite the rise in inflation. So, too, for other commodities such as copper, although oil prices have continued to ascend. Bitcoin and other cryptocurrencies might prove to be inflation hedges, though the jury is still out. Yields on Treasury bills, bank deposit accounts and the like also tend to climb during inflationary periods if interest rates are rising too, as is frequently the case.
A key reason stocks can flourish in a modest-inflation environment is that companies, especially big ones, often can pass along cost increases. Nick Colas, co-founder of DataTrek Research, believes that capability is more apparent today because of heavy investments in technology that have given businesses a better edge in managing expenses and knowing how to pass those costs along.
Gradual changes are less worrisome
Stocks and even bonds, to a lesser degree, can realize decent returns during inflationary periods. Investors tend to tolerate inflation as long as it doesn’t come in big waves.
In recent decades, overall stock returns have been fairly consistent — ranging from about 11% to 15% annually including dividends — whether inflation was high, low, rising or falling, according to a study by JPMorgan Funds. One caveat, though: The results were compiled from 1988 through 2020 and thus reflect a period when inflation was fairly stable, averaging about 2.5% a year. It didn’t gauge the impact on stocks when inflation gyrated more wildly, as in the 1970s and early 1980s.
The study similarly found fairly consistent results for bonds over that 33-year period, with returns (including interest payments) clustered between 5% and 9% annually, regardless of the inflationary backdrop.
However, bond prices can drop sharply if interest rates are surging. For example, a jump of one percentage point in the general level of interest rates would lead to roughly a 20% price loss on 30-year Treasuries. Bond yields or interest payments would cushion the blow only so much.
Lower-rated bonds could hold up better in a rising-rate environment than those issued by governments. Partly this is because they pay higher yields, and partly it’s because their values are tied more closely to credit-risk factors.
What about real estate?
Like gold and stocks, real estate including housing is widely seen as an inflation hedge. “In the 1970s, when consumer prices rose by an average of more than 7% per year, median new home prices rose by more than 9% annually,” wrote David Kelly, chief global strategist for JPMorgan Funds.
Inflation also ties into mortgage rates and thus home affordability. Expectations for future inflation help drive interest rates including those on 10-year Treasury notes, to which long-term mortgages are pegged.
Mortgage rates tend to run about 1.75 percentage points higher than the yield on 10-year Treasuries, observed Lawrence Gillum, fixed-income strategist for LPL Financial, though the gap has been narrower lately. That 1.75 point difference is a “rough estimate of the costs associated with originating a mortgage loan,” he said.
Gillum expects the 10-year yield to end in 2021 between 1.75% and 2%, which could push up rates on 30-year mortgages to around 3.5% or a bit higher. Earlier this year, 30-year mortgage rates bottomed near 2.8%. They’re currently around 3.2%.
Putting it into perspective
Although inflation is getting more attention this year, it’s still nowhere near where it was in the 1970s and early 1980s. Inflation averaged 7.4% annually during the 1970s. It hit 13.3% in 1979 and 12.4% in 1980.
Since then, Federal Reserve efforts to keep inflation at bay have worked. So have trends such as the graying of America (older people don’t buy as many cars, appliances and so on), technological innovations (computer prices have plummeted), the surge in inexpensive foreign imports and more. In recent years, inflation has mostly hovered around 2%, though it hit 5% over the most recent 12 months, through May 2021.
Prices for used cars and trucks have been markedly higher lately. So, too, for gasoline and airfares, reported the Bureau of Labor Statistics. But price changes have been more subdued for other goods and services, including health-care costs.
The future course of inflation is perhaps the most widely debated topic in economic circles right now. Some observers anticipate a new era of higher price levels, but others view the recent rise as temporary, reflecting “reopening flukes” for businesses from the coronavirus pandemic. As the business climate returns to a more normal footing, they expect inflation will fall back into line.
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