By John Cunnison, CFA
Over the course of history, a tight relationship has emerged between inflation and employment levels. This correlation is sometimes referred to as the Phillips curve and represents a foundational economic concept — when employment goes up, so does inflation. The supporting intuition is very simple. If more people are making money, there is greater demand for goods and services. So if supply stays about the same, prices increase. By the same token, when employment comes down, inflation decreases as well.
However, a fundamental breakdown in this correlation has occurred over the last few decades. For example, we saw record levels of employment just before the pandemic without any notable corresponding spikes in inflation.
Two of the prominent questions are “Has that relationship been severed?” and “If so, for what reason?” It’s probably too soon to definitively say that no correlation will exist anymore. But there are two leading explanations for why the relationship has been lacking in recent years.
The first pertains to demographics within the world’s largest economies, including the U.S., China, Japan and several European countries. Previously, population curves for these countries tended to look like “Christmas trees.” The top of each tree, representing older people, was narrow; while the base, indicating younger people, was much wider. As a result, these economies enjoyed relatively consistent stimulation by large numbers of new workers and corresponding new spending.
Today, that Christmas tree in many developed economies is starting to appear far more top heavy, with a higher percentage of older people and lower percentage of younger people compared to the past. This makes it more difficult for governments to supplement the incomes of retirees, because there are fewer younger workers to pay the supporting taxes.
Additionally, older individuals tend to not spend as much as younger folks. They typically aren’t raising children or buying houses. Older individuals are also generally less interested in the latest cars or technology. In fact, we often see that spending rates of people in retirement can decline almost linearly.
Technology is the second factor widely thought to be impacting the relationship between inflation and employment. The driving force behind this argument is Moore’s Law, which states that every two years, the number of transistors on a microchip multiplies by two, while the cost of computers is cut in half. So essentially, technological advancement results in massive computing power fitting into ever smaller packages at decreasing costs, an inherently deflationary scenario.
Your smartphone offers a great example. Although it might seem a little pricey depending on what model you purchase, consider that this device can eliminate so many other potential expenditures by serving as your camera, flashlight, alarm clock, media source, watch, etc.
Due to the pandemic, central banks around the world are engaging in all-out efforts to actually stimulate inflation and support the global economy. One of the challenges we’re likely to face in the near future is the supply-and-demand dynamic.
Demand for many goods and services has been depressed due to the pandemic, leading to corresponding decreases in supply. But with vaccinations becoming more widespread, demand should soon begin to surge. Supply will likely increase in response, though perhaps not immediately.
As a result, there could be a period of time as we emerge from the pandemic where inflation begins to run. The concern is how people will react. Baby boomers lived through sky-high inflation during the 1970s and tend to be very fearful of it. A number of baby boomers are in policymaking positions today, so if they believe 1970s-style inflation is about to take off again, there could be great pressure on central banks to start increasing interest rates in an effort to cool the economy.
It’s a tricky situation because short-term inflation will likely occur regardless. But will it turn out to be persistent or just a result of supply needing a little time to ramp up and meet demand? If people prematurely make the argument that it’s persistent, central banks might move too quickly and actually push us into a recession.
What should retirees and pre-retirees be doing in light of this inflationary uncertainty? I would first caution that it’s incredibly difficult to forecast the kind of long-term, persistent inflation you’d want to protect against in your portfolio. There’s essentially a soup full of different ingredients that can drive inflation, like those previously discussed. Some are longer-term developments such as advances in computing power, while others are very acute like shifts in supply and demand.
But part of the reasoning for short-term inflation is that the pandemic caused the prices of many goods and services to plummet. Inflation is measured as a year-over-year change, so if prices recover even a little from crisis levels, it could appear to be a significant inflationary spike. In reality, those new prices might be considered relatively normal if it weren’t for the pandemic.
While inflation is notoriously difficult to forecast, being prepared for a range of outcomes represents a core portfolio principle. According to The Economist, “Financial markets imply a one-in-five chance that consumer prices will grow by at least 3% per year on average over the next five years.” Is it reasonable to consider that 20% possibility in your portfolio? I would say yes. Fortunately, some of the best tools for combating long-term inflation are pretty affordable today because there isn’t a high expectation it will be persistent.
On the bond side, the classic tool is Treasury Inflation-Protected Securities (TIPS). TIPS are excellent hedges against inflation, but they come with a downside. The “carry,” referring to what you get paid while waiting for inflation, is very low.
To address that concern, there are other funds that invest in corporate bonds rather than Treasury bonds and offer a slightly higher yield. Corporate bonds have a fixed interest rate, and some mutual funds will enter the market to swap that for a rate of return indexed to inflation. So a trading partner must be found and there’s a cost to execute the transaction, but it can be reasonable, especially if the market isn’t predicting persistent and rising inflation. Again, the downside currently is a very low interest rate.
Bank loans provide another potential option, with slightly more credit risk but typically short durations. Many bank loans have an adjustment mechanism, so the interest rates increase periodically based on prevailing commercial lending rates.
Commodities are traditionally a staple in the inflation fighter’s toolkit. Investors can choose between direct exposure in a commodity fund and indirect exposure by way of natural resource equities. Either is a reasonable choice, though I have always preferred the latter, as direct exposure is simply a speculative bet on commodity prices. Generally speaking, natural resource equity exposure can represent a long-term source of compounding return.
The best long-term inflation hedge has simply been stock exposure. Some stock sectors merit strong consideration as inflation fighters. These include consumer staples with strong brands, which tend to have pricing power. For example, let’s say you normally pay $2.50 for a tube of your favorite toothpaste. If that price suddenly rises to $2.75 due to inflation, you’d probably still buy it without blinking an eye.
Another good option among stocks are companies with government contracts, because inflation protection is often built into them. Health care has traditionally been an appealing sector as well. People need medicine, so medication prices will usually rise with inflation. It’s important to remember that all of these sectors should be included in a well-diversified portfolio, so the goal here is not necessary to build an equity portfolio around inflation-fighting sectors.
From a high-level perspective, it’s also important to understand how biases can impact the decisions that investors make. Significant research has been done on the ways that people think about investing. One interesting conclusion is that their viewpoint can be heavily influenced by how the market behaved during their formative years.
Let’s look back at the example of the 1970s. This decade is known for bonds actually outperforming stocks, and people who were in their 20s or 30s around that time likely remember significant inflation. So it’s not surprising they tend to see inflation as very pernicious and difficult to control.
I would recommend that investors be as aware as possible of any biases they might have. One way to do so is by taking a close look at how markets are pricing the potential for inflation, because that will offer a good quantitative check on what your gut could be telling you. I’d also suggest working with an expert financial advisor who can provide an objective viewpoint, helping you identify and avoid being overly influenced by biases that may be hidden.
About the author: John Cunnison, CFA®
John Cunnison, CFA®, is vice president and chief investment officer at Baker Boyer in Walla Walla, Washington. In spearheading investment management at Baker Boyer, John works to construct and maintain tax-efficient portfolios. Among his areas of expertise are economic trends, behavioral finance, portfolio construction, and factor- and evidence-based investing.