Inflation, transitory or cause for concern?
By Jason Maniotakis, CFA, CFP® 16 June 2021 9 min read
Written by Jason Maniotakis, CFA, CFP®, co-authored by Alexander Jones, CFA and Daniel Spencer, CFA on behalf of Private Investment Counsel, who believe in a holistic investment counselling approach to helping high net worth clients.
I was talking about inflation with a colleague of mine and he shared this story about his great grandparents, Donald and Mabel Kennedy. Donald was a Scotsman and he moved to Canada in the 1920s for the same reason many people did at the time; to build a better life. The couple settled under the Homestead Act near Fairview, Alberta in Peace County, not far from the Dunvegan bridge.
Unfortunately, after 25 plus years of ranching, Donald passed away in the 1950s and the family ranch was sold as family dynamics made the continued operation of the ranch no longer feasible. The family received approximately $50,000 for the ranch, which was a large sum of money in the 1950s. Mabel took the proceeds and invested in railway bonds for approximately 30 years at four per cent interest rate. This action made perfect sense to her— it provided protection from stock market volatility, and the interest payments were sufficient enough to support her lifestyle.
For the next 30 years, she lived off the promised interest, but during the high inflationary period in the 1970s and 1980s, the four per cent interest she earned on the initial principal bought considerably less and less each year. The bonds matured in the late 1980s after Mabel had passed away, and the $50,000 in principal she left for her grandchildren bought much less than $50,000 did back in the 1950s. The Kennedy family experienced first-hand the erosion of purchasing power caused by inflation over a long period of time.
Inflation is a hot topic these days. While some concerns are legitimate, how things play out over the next few years remains to be seen. Will we see a period of higher inflation that causes interest rates to rise? Or, will inflation stay at lower levels than expected, allowing central banks to keep interest rates lower, for longer?
As long-term investors, we do not spend much time trying to predict the direction of macroeconomic factors. We know inflation exists and that it’s a real cause of wealth destruction over the long-term, so we focus on strategically combining a mix of investment assets that have historically provided a rate of return in excess of inflation. We know that, over time, well-run companies can increase their prices—and hence their revenues—to offset the impact of higher costs due to inflation.
What about now?
For multiple decades we have experienced lower-than-average inflation. Living through a pandemic-induced economic slowdown (to put it mildly), demand and inflation were reduced to a point where the prospect of deflation was a topic of concern just one year ago. Governments and central banks responded with historic levels of fiscal and monetary stimulus not seen since World War II. This proved successful in keeping demand from completely collapsing, and in warding off initial fears of deflation.
In hindsight, many investors are now worried that the efforts to bolster the economy during 2020 may have actually over-stimulated the economy. This may lead to rising prices and higher interest rates, which could stunt the continued economic recovery and the subsequent investment performance moving forward. However, a manageable level of inflation is often a healthy byproduct of economic growth, just as rising bond yields signal optimism that economic growth will be higher in the future.
Inflation can be broadly defined as the reduction in purchasing power, or a rise in prices over time. Typically, Canadian inflation is measured by Statistics Canada’s Consumer Price Index (CPI), which tracks price changes by comparing the cost of a fixed basket of goods and services over time. This basket of goods and services captures eight representative everyday components, such as food, shelter clothing and education.
Central banks typically target a two per cent long-term inflation rate, and consider a range of one to three per cent to be normal. The CPI in Canada rose 3.4 per cent on a year-over-year basis in April, up from a 2.2 per cent gain in March. The US saw similar increases. On the surface this seems significant; however, this increase may be largely attributed to the significant decline we saw at the onset of the pandemic a year ago.
Transitory or persistent?
Inflation shocks can be distinguished between short-term transitory or prolonged, or persistent. Transitory inflation typically arises when economies are in transition from sharp contractions to sharp expansions in economic activity, much like we have seen over the past year. Transitory inflation is temporary, as price hikes gradually subside as supply catches up with demand.
A recent example of transitory inflation is the price of lumber, with prices soaring over 400 per cent in the past 12 months. However, at the time of writing, lumber prices are down about 20 per cent from their record high in May of this year. The pandemic-driven home improvement trend increased the demand for lumber and outpaced supply. With production and supply now catching up, lumber prices are easing from their May highs. If the price of lumber continues to converge to its long-term average price, this would be a perfect illustration of transitory inflation.
Persistent inflation is evident when there is a constant acceleration in prices that lasts for many years. It typically arises from structural changes in the economy, and is something central banks look to manage over the long-term. Central banks will typically raise short-term interest rates in an attempt to slow the pace of persistent inflation, and keep it within its one to three per cent long-term target range.
How do we manage inflation risk in client portfolios?
It’s unlikely that any country can indefinitely increase its debt faster than its GDP growth without experiencing negative consequences such as high inflation, rising rates and/or a depreciating currency at some point. That said, “at some point” is the unknown. As it sits today, there is no indication that inflation will or will not persist moving forward. Similar concerns surrounding the potential for inflation and high interest rates were evident at the end of the financial crisis in 2009, due to fiscal stimulus and government bailouts. However, that forecast never came to fruition. In fact, inflation over the past decade in the US has been below it’s long-term average and interest rates have fallen to historic lows, fueling one of the best decades of asset price appreciation in history.
One of our primary tools to combat the impacts of inflation is to invest in a globally-diversified basket of stocks. Well-managed companies can increase the prices they charge to offset the increase in costs they experience from inflation. If they can grow their revenues at a rate higher than inflation, this should reflect in their stock prices over time. Some companies are better at this than others, and some companies have built this directly into their business models. The sub-advisors we hire to select stocks understand this and incorporate this into their ongoing research processes.
An example of this is Visa Inc., a company we own in our US equity strategy, and one that is able to insulate its business from the effects of inflation. Our active US equity strategy is managed by Calgary-based Mawer Investment Management. When explaining how they manage inflation risk, Portfolio Manager of US Equity, Colin Wong, says "we don’t know how inflation will play out, so spend little time trying to determine if inflation is sustainable or temporary. Instead we stick to our strategy of looking for resiliency in the business models of the companies we own. We want to invest in wealth-creating businesses, with excellent management teams, that are trading at a discount to their intrinsic value. We believe this approach will benefit clients over the long-term, no matter what happens."
Mawer Investment Management Ltd. has allocated a position to Visa Inc. because it's a great example of a resilient business that will do well, regardless of changes in the inflationary environment. The credit card industry has high barriers to entry; a new competitor needs to sign up with thousands of banks and millions of merchants, and issue billions of credit cards. They are set up to naturally benefit from inflation, as the fees they charge are based on a percentage of the transactions they process. If inflation causes prices to go up, the revenue received from each transaction automatically increases. Mawer also feels that Visa Inc. will continue to benefit from the automation of their processes and should be able to continue bringing down their expenses, even in an inflationary environment.
Inflation does not change at the same rate for each country's economy at the same time, or to the same levels, which highlights the importance of global diversification in ATB’s portfolio management process. Investing around the world allows us to mitigate the risk of any sort of economic headwind in a particular country. Many of the headlines we see are American and Canadian-focused but the fact is that there are many other investment opportunities outside our borders that don’t face the same inflation risks we see in North America today.
It doesn’t matter whether an investor's objective is to preserve capital over time, to provide an income to support their lifestyle in retirement, or to simply maximize long-term growth. All of these objectives are best managed using a portfolio strategy that contains a strategic mix of assets that include some exposure to equities to combat the impacts of inflation.
Investing based on goals and planning
Just like we cannot predict today where inflation rates will go tomorrow, Mabel could not have been able to determine where inflation was headed in the 1950s. Nor could she have predicted the high inflation experienced in the 1970s and 1980s. What we do know is that regardless of what inflation does in the short-term, in the long-term it is a real risk to our clients’ wealth. We also know that, hIstorically, a globally-diversified portfolio of equities has provided a return that far exceeds inflation over the long-run. Even if we have a small allocation of equities in a portfolio, we expect to preserve and grow capital in real, inflation-adjusted terms over time.
Inflation, and a subsequent change in interest rate policy by central banks, can accompany a recovering economy. What we don’t know is if inflation rates will exceed, or fall short of, expectations already built into current bond yields and equity market valuations. Our investment philosophy will always be centered around hiring sub-advisors who look for quality companies that are able to thrive and compete in a variety of economic environments. If a company’s success hinges on a specific macroeconomic outcome, it’s likely not one that would be included in client portfolios.
All lasting successful investing strategies are goal-focused and planning-driven. Failed investing strategies are usually market-focused and current events-driven. It’s tempting to alter an existing investment strategy to factor in economic forecasts, but we believe better outcomes are generated by controlling what we can control, and understanding that risk is something to be embraced and managed; not avoided entirely.
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