In 2021 Markets Went Up…So Did Inflation

As we exited 2020, investors looked forward to turning the page on the health and economic impacts of the pandemic, and for most of 2021 they have been rewarded, as markets have rallied and the economy moved from recovery to expansion. Amidst this good news, however, has been the specter of new Coronavirus variants (whose impact is still uncertain) and on the economic front--rising inflation, with prices and wages going up at the same time. Here’s why and what it means for investors.

Why are prices rising? 

Quite simply prices are rising because demand is outstripping supply. People want to buy more of everything than the economy can supply.  

In response to the pandemic, the U.S. government and Federal Reserve created about 2.5 trillion new dollars, borrowed another $2.5 trillion, bought bonds to stabilize markets and sent checks to people and businesses. It worked. People have spent/are spending this money, the COVID-induced recession was short-lived, and the economy (and markets) rebounded quickly. However, the “supply chain” to deliver goods has struggled to catch-up, and business cannot find enough workers to meet the demand for services.

Will inflation continue? 

Historically, there has been some momentum to inflation, as higher property prices feed into higher rents and rising input costs and wages lead to higher prices for finished goods, so further price increases are possible. 

However, long-term interest rates have not yet risen, suggesting that bond markets expect inflation will be short lived. If supply-chain wrinkles are smoothed out, and businesses can adjust to adequate staffing levels, inflationary pressures may indeed prove to be “transitory” (in the words of the Fed). If these issues take longer resolve, and/or prices continue to rise, the Fed may be forced to take steps to “cool things down” by accelerating “taper” and raising interest rates.

How could this impact my portfolio? 

The relationship between interest rates and the various holdings in a diversified portfolio is difficult to predict. There is some expectation that if the Fed does raise interest rates, Growth stocks will underperform Value stocks. This is based on the idea that Growth stocks derive more of their price from profits that are farther in the future, and higher rates would impact the discount rates used to determine the present value of those future cash flows. Based on that logic, higher rates would lower the valuations of all companies, but it would hit Growth companies particularly hard. While we believe in general in overweighting Value stocks (as well as stocks that reflect other factors of return), this risk to Growth suggests that investors should take another look at their portfolios and make sure they are not over-allocated to Growth stocks. Growth has had a great run in recent years, but it can’t and won’t last forever.

The threat of inflation is also a reminder of the importance of investing in stocks generally. Through bear and bull markets, stocks, historically, have offered long-term returns significantly above the rate of inflation.

No one likes to pay more for gas or electricity or holiday gifts, but all signs indicate that this bout of inflation will ebb (with the help of the Fed) in the medium term.