Positioning your portfolio for price stability and growth.
Persistent inflation and real-world price volatility are driving uncertainty for consumers. The significant fiscal and monetary stimulus provided to combat the pandemic-related economic lockdowns is now manifesting as the highest inflation the U.S. has experienced in about 40 years. With the consumer price index showing an 8.5% 12-month increase in July, consumers are being squeezed by a combination of rising prices and wage growth that is not keeping pace.
The current inflation rate has been driven by component parts that can be considered transitory or sticky. Transitory components are those that are more discretionary to the consumer or driven by volatile commodity prices. We have already seen energy prices trade down from the highs reached earlier this year. While natural gas prices remain elevated and volatile, crude and gasoline have fallen significantly from June highs. This has provided some relief in gas prices at the pump. Since the highs reached in June, natural gas is lower by over 2.5%, although with significant volatility. Crude oil is down 22.5% from its June high, and gasoline is down over 25%.
Costs that are sticky include housing, health care and, more recently, travel and hospitality-related goods and services. While that last category has been resilient in recent months, that upward price pressure may not be as sustainable as that found in housing and health care as it is more discretionary. The increases in house prices, rents and interest rates have driven housing costs higher for both renters and homeowners.
Consumer demand remains strong despite rising prices, although this is in part due to consumers spending more to compensate for higher prices. In other words, individuals might be buying the same quantity, or even less, but spending more because of higher prices.
Watch changes in money supply
Money supply has also been a major driving force behind the acceleration and level of inflation. The M2 measure of the U.S. money supply includes cash, checking accounts, CDs, money market funds and other liquid easily convertible instruments that are close to cash. Over the last five years, M2 has grown from $13,558.9 billion to $21,667.5 billion. This is a change of 59.8% in five years, or a compound annual growth rate of over 9.8%. From February 2020 through June 2022, that compound annual growth rate is nearly 15.6%. This jump in the annualized compounded rate is mainly due to the large increase from February 2020 to May 2020. Since then, the rate of increase has slowed, and year-to-date 2022 it is essentially unchanged. If the M2 remains steady or increases at a more normal rate, this will also alleviate upward pressure on prices.
Real-world price volatility
While housing costs have risen at a brisk pace since the pandemic began, the volatility in interest rates has contributed to general uncertainty in the housing market. With 30-year mortgage rates jumping from 3.5% to over 6% and back down to around 5% in a short period, potential homebuyers are faced with a further challenge. In addition to the hurdle of securing adequate funds for a down payment, new homebuyers must now consider the mortgage payment in a different context as well. After all, the difference in payment between a 3.5% mortgage and 6% mortgage is significant for many would-be buyers.
Businesses also face this uncertainty as their cost of capital has become unusually volatile in recent months. New capital projects may be put on hold as financing costs rise, or the general uncertainty may cause some managers to place expansion initiatives on the back burner in favor of riding out current conditions in anticipation of more certainty in the future.
Underwhelming wage growth
Nominal wages for labor have experienced some of the highest growth in decades. Unfortunately, this comes at the same time as 40-year high inflation, causing the net result to be negative wage gains for the average worker. The chart below illustrates this point. At the beginning of the pandemic, nominal and real wages moved significantly higher as inflation was still muted. While wage growth has continued at a higher level, inflation has more than caught up, sending real wages further into negative territory than what was seen during the 2008-2009 financial crisis. The real gains in wages during most of 2020 were likely aided by stimulus programs in addition to the low level of inflation. This real gain was a significant driver of increased savings rates and savings for most consumers. Unfortunately, that is no longer the case and consumers are experiencing eroding purchasing power for both staples and discretionary items.
Despite rising inflation and volatility of prices for goods and services, the unemployment situation remains strong. With the July jobs report released, the unemployment rate dropped to 3.5% after the economy added 528,000 jobs. It is reasonable to expect wages to continue growing, at least in nominal terms, given the tight labor market.
The misery index is a simple composite of the inflation rate and unemployment rate. So while we are experiencing high inflation, it is offset in part by the low unemployment figures, keeping the misery index at a more reasonable level. The chart shows that this index spiked to levels nearly twice as high during the 1970s and peaked around 1980. We are nowhere near that level now, and given the positive momentum in jobs combined with the downtrend in commodity prices, we are unlikely to experience that same level of “misery” seen in the 1970s and 1980s.
The other side of inflation
Given what is discussed above, it is not difficult to make a case for not only avoiding recession, but also a continued period of growth and relative prosperity. Volatility in commodity prices and interest rates will need to decline for that to be possible, but that seems likely. While we may settle at levels higher than what we had before the pandemic, the prospect of 3% to 4% inflation, 5% 30-year mortgages, and 3.5% to 4% unemployment would form a solid foundation for the next cycle of economic growth.
If something that resembles that scenario comes to fruition, the question is what areas of the market are poised to thrive in that environment? My first thoughts take me back to mega cap tech, but also technology that promotes further efficiency gains and in some cases could be considered deflationary.
The case for lower inflation, price stability, and strong economic growth might seem overly optimistic to many. However, I believe the foundation for this is forming right now. I am confident that inflation will subside based on the factors discussed above, notably, easing commodity prices, stability in money supply and the resolution of supply chain issues globally. I expect demand for some goods to moderate as well. With mortgage rates materially higher than they were a year ago, I expect some leveling off in housing prices, a significant contributor to high inflation. It is also reasonable to expect travel and leisure-related costs to stabilize as consumers return to more normal patterns while business travel remains muted.
The most direct beneficiaries of the economy resuming more stable growth will be within the tech industry, both short term and long term. Long-term labor supply shortages can be alleviated in part by greater use of robotics and automation, an area that is investible today. Like with most of my suggestions, I recommend a diversified and low-cost approach to capture the gains over the long term. Compounded returns from investing occur over years and decades, not weeks and months, and these ideas reflect that. Any tilts within your portfolio allocations should be sized in a way that aligns with your risk tolerance and preferences. I look forward to your feedback in the comment section below.
Craig Blanchfield, CFA, is a professional portfolio manager and investment analyst who advises clients on all aspects of investment strategy, asset allocation and investment selection.