2021 Second Quarter Market Update- Let's Talk About Inflation

Q2 Recap:

Before we begin discussing inflation, let’s take a quick look at what happened to investments in Q2.

Following an explosive 9 month run, small cap stocks slowed their pace of growth allowing large cap stocks to nearly close the gap for the year. Meanwhile, international markets underperformed U.S. markets. This is not surprising. To many other nations, the U.S has had a fairly productive vaccine rollout and therefore many components of the U.S. economy are back to a semblance of normalcy. As international stocks become even cheaper (relative to U.S. stocks), at some point that may present investors with an opportunity.

Bonds are still struggling for the year, but they performed much better in Q2 than Q1. The current environment is a very difficult one for bond investors. With ultra low interest rates and a stock market that is flying high, bonds will naturally underperform. It's important to not look at bonds as a high return tool but instead view them as a risk tool. When stocks face turbulence, bonds have long proven to be an anchor of stability helping smooth out the ride. 

Inflation:

Well, I’m really glad I waited to write about this topic! When I first thought about writing specifically on inflation back in February or March, all I really had was personal anecdotal evidence of rising inflation. That is to say I was seeing price increases and supply shortages, but the Fed was insisting inflation was essentially non-existent. Most dramatically I prepaid for some lumber for a home project in December. I paid $14 per board for the lumber then picked the boards up in March. When I picked the boards up from Home Depot I noticed that the sticker price seemed high. I compared the sticker price to my receipt and in less than 3 months the price had risen from $14 per board to over $21. That is an increase of over 50%!

This anecdotal evidence piqued my interest that maybe the Fed has it wrong and that inflation is going to be the story of the spring. Sure enough, CPI numbers came out higher than expected month after month. The Fed then changed its tune to concede that inflation is higher than expected but is merely “transitory”. More recently the Fed has become divided on the topic of inflation with certain members expressing concerns while others maintain that inflation is primarily transitory. 

I’ll concede that certain “price surges” we have witnessed as of late are temporary due to the bizarre pandemic induced circumstances of higher demand and strained supply lines. However, I firmly believe that due to the Fed printing press, employers offering higher wages, and the surge in suburban housing demand inflation is still being underestimated by the Fed. 

For example, take rising wages. Once employers begin to offer higher wages to employees it is very unlikely that those employers will claw back those raises. Instead, those higher wages will be passed down to the consumer. For an understanding of just how dramatic some of the “transitory” price increases have been over the last year see the chart below which illustrates one year price changes in (Lumber, Natural Gas, Corn, and Gasoline).

So what does potentially higher inflation mean for you and your portfolio? There are both challenges and opportunities when it comes to higher inflation. 

Higher inflation can often lead to higher interest rates which presents a challenge for bonds. Meanwhile, certain stock sectors perform better during periods of rising inflation. In very general terms, value stocks tend to perform better than growth stocks when inflation is higher. 

What is important to note is that we have experienced a relatively long period of low inflation. In my view, we are in a low but rising inflation environment. In this situation equities (stocks) are a better tool to maintain purchasing power than cash and bonds. 

The chart below from Hartford Funds demonstrates that stocks have done an admirable job of outpacing inflation during periods of low but rising inflation. You’ll see that when inflation is below 3% and rising stocks have outpaced inflation over 90% of the time.

Over the last year, we have taken some steps to protect against inflation and other market risks. As you may recall, in January we purchased a gold ETF in many of our portfolios as both an inflation hedge and a stock market hedge. Additionally, last year we initiated a position in Treasury Inflation Protected Securities (TIPS) in many of our portfolios. As we move forward in 2021, we will be carefully monitoring the inflation story and how that relates to your portfolio. Please note that these adjustments are not a deviation from our long term diversified portfolio investment philosophy. We aren’t becoming market timing investors; we are merely using the best information available to determine where relative value can be found without exposing your hard earned money to undue risk.

This commentary on this website reflects the personal opinions, viewpoints, and analyses of the Financial Strategies Group, Inc employees providing such comments, and should not be regarded as a description of advisory services provided by Financial Strategies Group, Inc or performance returns of any Financial Strategies Group, Inc Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Strategies Group, Inc manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

Written by: Brice Carter