David Nelson

David Nelson

Inflation is a hot topic lately. Since the start of the pandemic last year, we have seen pockets of price increases. Housing prices rose as people relocated and looked for more space. Food prices rose as people cooked at home more and supply chains were disrupted. Energy prices have been rising recently as severe weather swept the country.

On top of that, there has been a lot of concern about inflation due to government policies. The Federal Reserve has continued to increase the money supply by massive amounts. Since February 2020, currency and demand deposits at banks have surged by nearly $3 trillion. Congress has launched multiple large stimulus packages with direct payments and extended unemployment benefits.

With so much extra cash in the system, many are asking themselves if this will continue to drive prices higher. Unfortunately, the answer is: It’s complicated.

One of the reasons that it is complicated is that there are a couple distinct forms of inflation. The examples I listed above are what everyone notices most readily: the inflation in the prices of goods and services, broadly viewed using measures like consumer price inflation. However, there can also be inflation in the prices of financial assets like stocks and bonds. This can be harder to notice because financial assets are supposed to go up; that is why we invest in them. When there is a lot of money in the economy, it has to go somewhere. If people aren’t spending it, it tends to find its way into financial assets and can push up those prices higher than otherwise might have been the case.

This is an important distinction because asset price inflation and standard price inflation tend to be opposites of each other. One of the reasons that assets like stocks and bonds go up when standard measures of inflation, like CPI, are low is that they pay (or have expectations of paying) cash flows out into the future. If inflation is low, those cash flows are just as valuable tomorrow as they are today, and possibly much more so if it is a growing cash flow. However, when inflation is high, that future cash flow is much less attractive because that high inflation can erode the purchasing power and investors might prefer to have that cash today instead.

One way to gauge the balance of standard inflation and asset price inflation is by looking at what is called the velocity of money. It simply measures how quickly dollars are spent relative to the amount of money in the economy. When velocity is falling, it means that there are a lot of idle dollars and historically those are the ones that have found their way to financial assets.

We saw money velocity plummet in the first half of 2020 as the economy was flooded with dollars from the Fed, but spending was hampered by the pandemic. Velocity did pick back up in the second half of the year as the economy started back up, but still seems to be a race between money coming into the system and consumers’ willingness to spend.

While I talked about the pockets of inflation we have seen, overall CPI has remained benign. Other measures are a little more concerning. Manufacturing input prices have risen noticeably, and productivity has seen declines that have resulted in higher unit labor costs. Expectations of inflation over the next 5 to 10 years are at all-time highs when measured by comparing inflation-linked vs. nominal bond yields.

All of these metrics are worth watching closely. If we do see inflation pick up in meaningful ways, investors may find themselves uneasy with their current portfolios. Increasing inflation regimes historically see more correlation between stock and bonds prices. For the past 20 years, declines in stocks have been cushioned somewhat by rising bond prices. If that dynamic shifts, traditional balanced portfolios may see an increase in overall volatility. Investors should take the opportunity now to stress test their portfolio against inflation rates coming in at currently expected levels.

Diversification and asset allocation strategies do not assure profit or protect against loss. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including loss of principal.

David M. Nelson is president and CEO of NelsonCorp Wealth Management.

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