What Does the Soaring U.S. Inflation Rate Mean for Your Portfolio?
U.S. inflation has risen to its highest point since 1982, exceeding 7% in 2021. Some of this inflation is transitory, but not all of it, and it should be of particular concern for those with assets over $1 million in their portfolios.
In this article, we will analyze this inflationary trend, what caused it, if inflation will hit the same highs as in the 1970s, and what you can do to protect your portfolio.
Are we experiencing the same inflation as we did in the 70s?
This soaring inflation in the US began in 1972, following an economic boom and reached 12% in 1974 and 14.5% in 1980. During this time, unemployment numbers were low and growth numbers were high and when Nixon was re-elected, his policies contributed directly to one of the three large shocks that spurred this inflationary period:
The oil embargo
Discontinuation of the gold standard (part of “The Nixon Shock”)
Removal of Bretton Woods
Let us examine these three crucial events:
The 1973 oil embargo
In 1973, the Organization of Petroleum Exporting Countries (OPEC) “imposed an embargo against the United States in retaliation for the U.S. decision to resupply the Israeli military.” Oil prices in the U.S. doubled, tripled, and soon quadrupled due to the country’s dependence on foreign oil imports at the time.
The gold standard
Prior to 1971, the U.S. dollar was backed by gold. Nixon broke this tie, thereby turning the dollar into a fiat currency, devaluing it greatly. The result was what has become termed “stagflation,” a period of slow economic growth and high inflation.
Bretton Woods
The Bretton Woods agreement of 1944 pegged the currencies of developed countries to each other within a range, and foreign exchange prices did not move freely as they do now. These currencies were indirectly fixed to gold because the US dollar was fixed to gold. This agreement fell apart after Nixon separated the dollar’s value from gold and made it impossible for people to buy gold with U.S. dollars.
Today is not the same as the 1970s, but remains unprecedented.
The factors which contributed to the 1970s stagflation were seismic. These are not the factors we have today, and we don’t see that we will experience such enormous rises in inflation today as we did in the ‘70s.
Likely, inflation will be capped in the medium-to-long term. A primary reason for this is the world’s aging population and low or even negative population growth across many parts of the world. As has happened in Japan—a country with a weak inflation rate for the last 30 years—an aging population can slow down inflation. The ‘70s was the decade of the baby boomer generation coming of age and making big purchases.
What factors are currently influencing inflation the most?
Twin deficits and high debt levels in the U.S.
A trade deficit is when a country’s imports exceed the value of its exports. The U.S. trade deficit reached a record high of $1 trillion in January 2022.
A budget deficit exists when the government spends more than it receives in revenue (tax dollars). The U.S. has had a trade deficit since the mid-’70s and the last time the U.S. had a budget surplus was in 2001. Today, the COVID-19 pandemic has driven the US budget deficit to over $3 trillion.
This is in contrast to China which has operated in a trade surplus since 1995, reaching a record $676 billion in 2021. China’s 2021 budget deficit is also so low as to be nearly negligible.
Persistently high deficits must be paid for, usually by issuing debt and debt levels remain high in the US and across many parts of the world, both public and private debts. Economists tend to agree that high deficits and debt levels can trigger high inflation, as we are seeing now. The U.S. has been somewhat insulated from deficits causing inflation before COVID due to the US dollar’s status as a global reserve currency. However, this advantage can only delay the onset and reduce the magnitude of inflation as opposed to prevent it entirely.
Labor Supply Factors
There are currently several labor supply factors that will contribute to inflationary pressures in the short to medium term.
COVID deaths in the US and around the world have reduced the supply of labor.
The great resignation—the sudden spike in resignations in the U.S. and globally, which many feel is as a direct result of hardships and reevaluations of what is important because of the pandemic.
Restrictive migration policies: Many countries have experienced political pressure to reduce immigration relative to the prior several decades.
Housing costs. Soaring housing costs in the U.S. have made it more difficult for workers to move freely to where jobs are available.
Deglobalization
Deglobalization is another domino effect of the pandemic where countries are now considering a return to protectionism due to concerns of lack of international cooperation and national security.
Climate Change
Climate change is an existential threat to humanity, but it gets very little attention against the backdrop of inflation. In a research note last year, we discussed climate change and addressed the civilization and humanitarian costs that we are already witnessing. Weather related natural disasters are expected to become more common which will add more strain on global food supply chains. Water scarcity, increased food production costs and labor shortages will exacerbate today’s inflationary problems.
Russia’s War in Ukraine
Russia’s war in Ukraine will have a lasting impact on energy markets but how big the impact will be is difficult to predict. Russia is a significant supplier of oil and natural gas and has the world’s 11th largest economy. According to State Department, US officials are in active discussions with their Venezuelan counterparts to limit the impact of a possible oil embargo by Russia. An oil, or even wheat, embargo by Russia will certainly exacerbate global inflation. Russia is the world’s largest exporter of wheat, while Ukraine is the 5th.
What should investors do?
There is no historical precedent for what is occurring right now. COVID-19 was a black swan event and its impact on the economy was unpredicted.
An experienced portfolio manager is essential to help you understand the potential risks to your portfolio. The greatest potential risks exist for individuals with net assets of at least $1 million, with risks increasing as the value of one’s assets increases. That changes will need to be made to portfolios of such value is almost guaranteed.
The devil is in the details, requiring specialized analysis according to the types of asset classes you have invested in. A thorough analysis of your portfolio by an expert is crucial.
On the bond side, one should be aware of the level of interest rate risk their portfolio is exposed to. Interest rates are still low and sustained high inflation could have a significant negative impact on bond prices. One can possibly structure a portfolio to have low-interest rate risk or invest in floating-rate bonds that allow investors to profit from rising interest rates. This is just one potential option and cannot be given as a blanket solution without a deep analysis of the portfolio involved.
On the equity side, company valuations are very high relative to historical levels. High valuations and high inflation do not mix well. One or both sides of this equation will need to move to be sustainable over the long term. Investors may want to consider including hedging strategies into their portfolio. Overlaying a risk reversal strategy using derivates may make sense for some portfolios and is used by some sophisticated institutions.
Periods of high inflation are likely to favor active versus passive management. When inflation and interest rates are very low, many companies’ stock prices can perform well. A rising tide lifts all boats, so to speak. However, persistent inflation will force the winners to pull ahead from the losers.
There is no one-size-fits-all strategy. Your portfolio manager would need to determine what is best for your portfolio.
The founding partners of Elevate Capital come from institutional backgrounds and are experts in their asset classes. They worked with sophisticated multibillion dollar portfolios, and they apply similar strategies and techniques to their clients’ portfolios.
Elevate Capital is a San Francisco-based boutique investment advisor specializing in helping families and individuals with portfolios of at least $1 million. To learn about our concierge portfolio management services, contact us for a discrete, no-obligation chat.
Disclaimer: Nothing in this article should be construed as investment advice. This article is for informational purposes only. Please always consult with an advisor for specific advice regarding your portfolio.