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Inflation: Is There Light at the End of the Tunnel?

Inflation: Is There Light at the End of the Tunnel?

If you’ve turned on the TV or read the paper recently, you’ll know things don’t look good. Your 401(k) is well off its highs, gas is $5 per gallon… Heck, even the cash in your bank account isn’t safe. 

Yet, things may not be as bad as you think. Here’s the rundown on everything that is happening right now and (at the end) the reason for hope.

Chapter 1

2022 Stock Market Performance

As of March 7, 2022, the year-to-date performance of the three major indices are:

  • S&P 500: -11.86%
  • DOW: -9.69%
  • NASDAQ: -17.99%

After the sustained bull run which originally began in 2009—ignoring a few blips along the way—and careened through the COVID-19 slingshot, global equity markets have largely turned sour.

The tech-heavy NASDAQ has led the plunge lower: Many of the world’s largest companies have seen billions of dollars in market cap wiped away in the first three months of 2022.

Despite current headwinds (discussed next), there remain reasons to be optimistic. Still, volatile times like these can be painful.

A solid financial plan, built around your current needs and future goals, will absorb market downturns in-stride. No matter where the market goes from here, the right investment strategy is the one that gives you confidence today of a secure tomorrow.

Chapter 2

Current Headwinds

The poor performance of the stock market in 2022 can largely be attributed to the war in eastern Europe. However, that is not all. Inflation, stemming from monetary policy decisions since COVID-19, became a problem in early 2020.

Let’s take a closer look at each contributor in more detail.

1. Russia’s Invasion of Ukraine

As of the time of writing, it’s been about two weeks since Russian President Vladimir Putin launched his assault on Ukraine.

His aim, though still not totally clear, was most likely to topple the Ukrainian government and/or take control of some or all of the country.

Much has happened since the initial attack.

Russia vs Ukraine

By comparison of military force alone, Ukraine is outmatched. Russia boasts an impressive army, considerable technology and weaponry, and sheer size.

Despite Russia’s superior firepower, the Ukrainian people have fought passionately for their homeland, mostly thwarting Russia’s advancements thus far.

Unfortunately, the war has turned into a bitter struggle with an ever-growing list of casualties.

The Backdrop

For several months, the crisis along the Russia-Ukraine border was building. Putin moved men and supplies towards its neighbor to the southwest.

He has long advocated for Slav nationalism, stating that Russia and Ukraine were one country with one set of origins. The validity of that historical interpretation is apparently a matter of perception.

Additionally, Putin has also cited that NATO reneged on a pledge after the Soviet Union collapsed in 1991; that it would not expand into the former Soviet republics.

Again, the existence of such a pledge is likely unfounded. Ukraine, in return for recognition of its sovereignty, gave up its nuclear arsenal between the years of 1996-2001.

Regardless, Putin’s nationalism, military might, and propensity for irrationality cast much doubt over the eventual end of this drama.

Sanctions vs Guns

Though Ukraine’s allies have largely kept their militaries sidelined, Russia’s invasion of Ukraine has led to some of the largest economic sanctions in the modern era.

Russian equities have been removed from the S&P 500. Private businesses are shutting down operations and refusing to service existing contracts in Russia.

Meanwhile, powerful Russian business leaders and diplomats are having their assets seized. Hundreds of billions of the central bank’s foreign reserves have also been frozen.

A variety of other sanctions imposed by the U.S. and its allies have pushed many corporations to the point of collapse. The value of the Russian ruble is at record lows. Citizens have been lining up at ATMs, desperately trying to convert their flailing currency to hard goods.

To combat the currency devaluation, Elvira Nabiullina—the head of the Russian central bank—announced their key interest rate was being raised to a staggering 20%.

Russian stock and bond markets, as well as the ruble, have collapsed. Put simply, the Russian economy is in trouble.

Estimates by Oxford Economics indicate the Russian economy could shrink by as much as 7%. That is about twice the amount that the U.S. economy contracted during the Great Recession.

2. Inflation

Inflation is too much money chasing too few goods. It is the measure of the rate of increase in prices within an economy.

When inflation is at 2%, that means the aggregate cost of goods or services is increasing at a 2% annual rate.

What Causes Inflation?

Inflation occurs when the supply of money increases at a rate faster than total production increases.

If there is a 10% increase in the amount of money in an economy and a 2% increase in the quantity of goods or services produced, the aggregate cost of everything rises (assuming demand stays constant). It has to.

To illustrate, consider an economy that consists of $10 and 10 apples. Each apple is worth $1.

Now, if I increase the supply of money by 30% and leave production unchanged, what does it look like?

The economy now has $13 and 10 apples, meaning each apple now costs $1.30. That’s inflation.

Oversimplified example? Perhaps. But, although our economy is more complex, the example is illuminating (and economically sound, if you agree with Milton Friedman).

In response to the economic turmoil caused by the shutdowns related to COVID-19, the Federal Reserve decided to rapidly increase the supply of money.

They placed the newly minted stimulus in the hands of American consumers. This new money and increasing demand continues forcing aggregate prices higher.

The Hidden Benefit of Inflation

Inflation causes the value of currency to decline over time. In other words, cash today is worth more than cash tomorrow.

Lenders know this. They will charge rates that cover their loss in purchasing power due to inflation plus the amount to cover the risk of default.

Still, if inflation is running at 2% annually and you take out a fixed, 3% mortgage, you’re essentially paying just 1% to borrow the money.

The 1% effective rate you’d be paying is incredibly low—it pays to be a borrower. But, consider what happens when inflation rises further:

If it jumps to 4% and you’re only paying 3%, you’re now essentially being paid 1% annually to have a loan (though you won’t see that money in your bank account). So then, inflation isn’t all bad.

Mortgages, anyone?

Chapter 3

Raising Rates

In order to combat inflation, the Federal Reserve has outlined a plan to slowly begin raising interest rates. It begins with a 0.25% increase this month.

The Fed has the ability to adjust the Federal Funds Rate; the interest rate at which banks borrow and lend to each other. Raising this rate has a trickle-down effect whereby all other rates (mortgages, car loans, bank loans, et cetera) will typically rise at a commensurate rate.

Banks earn interest while they hold reserves. When the amount of interest rate they earn on reserves increases, they tend to hold more.

This results in lowering the amount of money they’re lending, which slows the economy and decreases inflation.

Additionally, as interest rates are increased, consumers tend to save more and spend less (also slowing the economy and decreasing inflation).

Several hikes of 0.25% are expected in 2022, with additional hikes likely to follow in the years ahead.

Inflation-Proof Investing

As mentioned above, inflation benefits borrowers.

For homeowners and real estate investors, you may be being “paid” to have your mortgages. Additionally, real estate may offer stability to your portfolio while other assets experience swings of volatility.

Plus, real estate returns tend to keep pace with (and slightly beat) inflation over the long run.

Outside of real estate, investors have frequently turned to precious metals and commodities such as gold and oil when inflation is running rampant. By converting their paper assets to hard goods, they seek to protect their purchasing power (similar to what Russians are attempting to do currently).

Equities, especially those with the ability to control their input costs and/or pass on price increases to their consumers, also typically fare well.

Additionally, investors may potentially look for commodities companies and materials firms to do particularly well.

Chapter 4

Inflation’s Impact on Retirees

Though rising prices affect everyone, they do not affect everyone equally. For those who are still working, rising costs are offset or partially offset by rising incomes.

If your wages are adjusted for inflation, your purchasing power (how much stuff your money can buy) will remain largely unchanged. If aggregate prices rise 5%, most workers will see about a 5% increase in wages.

But, what about those who are no longer working? How do retirees maintain their purchasing power in periods of high inflation?

Unfortunately, inflation is essentially a tax on savings. If your money is earning interest at a rate lower than the current level of inflation, your savings are slowly becoming worthless.

So, how should you adjust your portfolio to combat inflation?

Bonds may provide stability, but even with rising interest rates, they won’t provide much in the form of returns. Equities, which typically outperform bonds, aren’t stable enough to be an elegant solution.

What you need is the right blend of assets held in the right combination of accounts. Pair it with an income and savings plan to get you through these times and into smoother water.

Get a financial plan created to weather any environment—so you can focus on your retirement, not the gyrations of your portfolio.

Social Security

50 years ago, Congress enacted the COLA (cost-of-living adjustments) provision. This automatically increases Social Security benefits to match the Consumer Price Index (CPI-W) each year.

The goal of the provision was to ensure the purchasing power of Social Security and Supplemental Security Income (SSI) benefits are not eroded by inflation.

In 2020, inflation was subdued, resulting in a COLA in 2021 of 1.3%. Current projections estimate a cost-of-living adjustment as high as 6.2% in 2022.

Chapter 5

Volatility and the Stock Market

Have you ever thought about why the U.S. 10-Year pays 2%, while equities’ long-run average is around 8%?

The answer: Risk.

Returns are correlated with the level of risk you take on. The higher the risk, the greater the expected returns you will require for subjecting yourself to that risk.

Since there is an extremely high probability of repayment when you buy Treasuries, investors do not require much of a return.

However, when you buy stocks, you will encounter volatility. So, you must have the resolve to hold on if you want to enjoy positive returns.

We also must not forget that intra-year stock market declines are normal and should be expected. The chart below shows the annual returns of the S&P 500 and its largest decline in that calendar year:

It’s crucial to stick with your long-term investing strategy during moments of volatility. Proper financial planning will guide you through times of market turbulence.

If you lack confidence in your current financial plan, talk to your current advisor or reach out to us for a second opinion.

Will China Sell Its U.S. Debt?

China has long been expected to attempt to re-seize control over Taiwan. As Russia targets Ukraine, many believe now will be the time when China makes a move of its own.

That said, China is far more involved in global finance than Russia. The sanctions being imposed on Russia have had a crippling effect on its economy.

That fact, alone, may be enough to deter China.

The new fear is that, even if China doesn’t invade Taiwan, it will dump its more than $1 trillion in U.S. government debt to preemptively avoid financial retaliation. This would send interest rates soaring.

However, a Chinese sell-off of Treasury debt would have little impact, both on interest rates and the broader economy.

China holds just 3.6% of all outstanding U.S. debt. Even if it were to sell it all, the shock would be momentary; not a death blow.

Despite extra deficits, temporary quantitative tightening, and persistent shortages of new homes, U.S. interest rates have remained incredibly stable.

If China sells our debt and swaps dollars for another currency, whoever gets the dollars would likely buy U.S. bonds, leaving things relatively unchanged.

All that to say, China invading Taiwan would be a horrible event. But, the fear of China harming the U.S. economy by selling Treasury debt is, in our opinion, overblown.

Chapter 6

The Light at the End of the Tunnel

Two things are abundantly clear: We are facing major headwinds and the future is largely unknown.

However, corporate earnings have remained robust and current economic conditions don’t signal a reason for that trend to slow.

COVID continues to wind down while demand for workers has driven wages higher and given individuals a lot of bargaining power.

Finally, monetary policy, though it may be restrictive in nature, was long overdue for a major shift. Despite its short-term negative ramifications (cooling the economy), it is likely the correct move to extend the current economic cycle.

Given all of the negative news, a sell-off makes sense. But the fundamentals are largely unchanged—and the winds of change are still predominantly tailwinds.

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