Hot Hike Summer
It’s hard to believe we’re only four hikes and just over four months into this hiking cycle. The Federal Open Market Committee raised its target policy rate by another 75 basis points to an upper bound of 2.50%. It was a widely anticipated move. As usual, the real news was in Chairman Powell’s comments after the announcement as markets tried to decipher what the path forward looks like.
The stock market liked what it heard. I think the right thing to do is to continue focusing on inflation as the main enemy, but the reaction in both the S&P 500 and the Nasdaq struck me as outsized positive moves given the Fed’s clear commitment to hiking further. I won’t be surprised if we give some of it back in the next couple days — after all, markets do tend to overreact in the short-term.
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However, I do think this is the last 75 basis point move we see out of the Fed, and markets may be readying for a more gentle hiking cycle into the fall.
Resolve Reiterated
Despite increasing fears of recession and many wondering whether a recession would slow the Fed down, Jerome Powell reiterated that they still have the tools and the resolve to bring prices down. He even pointed out that the tightening in financial conditions driven by the Fed hikes is likely to include below-trend economic growth and some softening in labor market conditions.
What I heard was, regardless of the collateral damage that could result from rate hikes, it won’t stop the Fed from charging forward.
Good. It shouldn’t, in my opinion. The whole goal of this process is to create slack in the economy that alleviates the upward pressure on prices. Slack leads to less demand, which leads to cooler inflation.
This is Tackle, not Touch
I also heard in his comments that there’s a bigger risk in doing too little, than in doing too much. Fighting inflation is a full contact sport and the level of slowdown that needs to happen in order to get it back in check is a level that will inevitably be felt by everyone.
The main question that remains is whether a deep and painful recession will result. My take at present is that inflation will cool in coming months enough to satisfy the stock market and allow it to find some upside. Economic and earnings data is also likely to show further signs of slowing, which could give the Fed clearance to reduce the size of hikes come September. Another “positive” for the market in the near-term.
What keeps me up at night is the possibility that inflation stays with us into 2023 and causes a recession that brings with it job losses and demand destruction for some time. The 2s/10s spread alone now clearly signals a recession could hit us in the next 6-18 months. Until we know more about that possibility though, I think investors may enjoy a market that grinds higher from here to the end of the year.
ABOUT LIZ YOUNG
Liz Young is SoFi’s Head of Investment Strategy, responsible for building out the function and providing economic and market insights. Prior to joining SoFi, Liz was the Director of Market Strategy at BNY Mellon Investment Management where she formulated and delivered views on macroeconomic themes and their effects on capital markets. Earlier in her career, she was a due diligence analyst at Robert W. Baird and a research analyst at BMO Global Asset Management. Liz is passionate about educating others on markets and investing in order to help people feel empowered to take a more active role in their financial futures.
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How to invest and profit during inflation
The inflation rate, or the rate at which prices are increasing, is going up in 2021, with the core U.S. inflation rate up to 5.4% in mid-2021. That’s a fairly big number, given the U.S. inflation rate stood at 1.4% only last January.
That has an impact on both consumers and investors. When inflation rises, consumer prices rise with it. Common goods like lumber, gasoline, semiconductors and grocery items like bacon and bananas have seen prices soar this year as a result of rising inflation, meaning that consumers’ paychecks might not go as far. If wages are rising at the same time as inflation, the impact on consumers is much less severe.
Rising inflation can also affect the stock market. Traditionally, rising inflation has tempered stock market growth, as consumers have less money to spend and the Federal Reserve may step in to check rising inflation by making loans and credit more expensive with higher interest rates.
What’s an investor to do when inflation is on the upswing? Often, it means adjusting investment portfolios to protect assets against rising prices and an uncertain economy.
Related: How can I invest $1,000?
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Inflation is largely defined as a continuing rise in prices. Some inflation is OK– historically, economic booms have come with an inflation rate at about 1.0%-to-2.0%, a range that reflects solid consumer sentiment amidst a growing economy. An inflation rate of 5% or more can be a different story, with higher rate levels associated with an overheated economy.
Inflation rates often correlate to economic growth, which is not always bad for consumers. When economic growth occurs, consumers and businesses have more money and tend to spend it. When cash is flowing through the economy, demand for goods and services grows and that leads food and services producers to raise prices. That triggers a rise in inflation, with the inflation rate growing even more as demand for goods and services outpaces supply.
Conversely, when demand slides and supply is in abundance, prices fall and the inflation rate tumbles as economic growth wanes. In 2021, however, the US economy is heating up after muted growth in 2020, and the inflation rate is on a significant upward trajectory.
In the United States, the main barometer of inflation is the Consumer Price Index (CPI). The CPI encompasses the retail price of goods and services in common sectors such as housing, healthcare, transportation, food and beverage, and education, among other economic sectors.
The Federal Reserve uses a similar index, the Personal Consumption Expenditures Price Index (PCE) in its inflation-related measurements. Economists and investors track inflation on both a monthly and an annual basis.
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Historically there are two types of inflation: cost-push inflation and demand-pull inflation.
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This type of inflation is an economic condition when goods and services are limited in supply, and where demand “pushes up” prices on those same goods and services. Take the cost of lumber in the first half of 2021, which was up substantially. Any increased price of lumber for building and construction leads to a lower lumber supply. With demand for lumber both sustained and intense, the price of lumber rises – or is “pushed” higher. Cost-push inflation also often occurs following a natural disaster (i.e., like when a hurricane closes oil refineries, leading to a lower supply of oil and gas, which leads to higher prices for both commodities.)
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This type of inflation occurs when prices rise in the consumer economy. When jobs are plentiful and consumer sentiment is high, or the government has pumped a large fiscal stimulus into the economy. People tend to spend more money on goods and services. Yet if the goods consumers are limited (such as smartphones or used cars), competition for those goods rises, and so do the prices for those goods.
Demand-driven inflation is often referred to as “too many dollars chasing too few goods,” meaning the competition among consumers for specific goods and services drives prices significantly higher.
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Inflation impacts both stock and bond markets but in different ways.
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Inflation has an indirect impact on stocks, primarily reflecting consumer purchasing power. When inflation rises, that puts pressure on stock market returns to keep up with the inflation rate. Consider a stock portfolio that earns 5% before inflation. Add the 5.4% inflation rate U.S. investors have seen (on average) over the past year, and the portfolio actually loses 0.4% on an inflation-adjusted basis. Plus, as prices rise, retail investors may have less money to put into the stock market, reducing market growth.
Conversely, some inflation stocks can perform well in periods of high inflation. When inflation hits the consumer economy, companies boost the prices of their goods and services to keep profits rolling, as their cost of doing business rises at the same time. Consequently, rising prices contribute to higher revenues, which helps boost the price of a company’s stock price. Investors, after all, want to be in business with companies that have strong revenues.
Overall, however, rising inflation raises the investment risk of an economic slowdown. That scenario doesn’t bode well for strong stock market performance, as uncertainty about the overall economy tends to curb market growth, thus reducing company earnings which leads to sliding equity prices.
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Inflation can crimp bond market performance, as well. Most bonds like US Treasury, corporate, or municipal bonds offer a fixed rate of return, paid in the form of interest or coupon payments. As fixed-income securities offer stable, but fixed, investment returns, rising inflation can eat it those returns, further reducing the purchasing power of bond market investors
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Investors can take several action steps to protect and potentially outperform with their portfolios during periods of high inflation. You don’t have to worry about choosing the best investments during hyperinflation, because it’s highly unlikely that runaway inflation will occur in the United States.
Choosing inflation investments is like selecting investments at any other time – you’ll need to evaluate the security itself, and how it fits into your overall portfolio strategy both now and in the future.
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For instance, investors might consider stocks where the underlying company can boost prices in times of rising inflation. Consider a big box store with a global brand and a massive customer base. In that scenario, the retailer could raise prices and not only cover the cost of rising inflation, but also continue to earn profits in a high inflation period.
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Think of a consumer goods manufacturer that already has a healthy portion of the toothpaste or shampoo market, and doesn’t need excess capital as it’s already well-invested in its own business. Companies with low capital needs tend to do better in inflationary periods, as they don’t have to invest more cash into the business just to keep up with competitors – they already have a solid market position and already have the means to produce and market their products.
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Treasury Inflation-Protected Securities can be a good hedge against inflation. By design, TIPS are like most bonds that pay investors a fixed rate twice annually. They’re also protected against inflation as the principal amount of the securities is adjusted for inflation, based on Consumer Price Index levels.
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Precious metals, oil and gas and orange juice can all be good inflation hedges as well. Most commodities are tied to the rate of inflation and can capitalize in high inflationary periods. Take the price of gasoline, which rises as inflation heats up. Businesses and consumers are highly reliant on oil and gas, and will likely keep filling up the tank and heating their homes, even if they have to pay higher prices to do so. That makes oil – and other commodities – a good portfolio component when inflation is on the move.
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By investing in short-term bonds and bonds funds, you’re not locked into today’s low rates for the long term. When interest rates rise, you can purchase new investments that reflect more favorable rates.
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Investors should proceed with caution when inflation rises. While low inflation can indicate a healthy economy, high inflation can be a precursor to a recession. Massive changes to a well-planned portfolio may do more harm than good, and you shouldn’t toss out a long-term investment plan shouldn’t be deep-sixed just because inflation is moving upward.
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This article originally appeared on SoFi.comand was syndicated by MediaFeed.org.
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