Inflation is coming, which sounds eerily similar to House Stark’s refrain in Game of Thrones, “Winter is Coming.” In many ways, it’s a reasonable metaphor.
Unlike the White Walkers, however, inflation is a topic that typically causes people’s eyes to glaze over. This isn’t surprising, considering nearly half the current U.S. population was not even born when inflation skyrocketed to 14% in the 1970s. Learning what inflation means and experiencing how impactful it can be for their financial well-being will be a first for many Americans.
Inflation is now coming back for a variety of reasons, and its significance should not be overlooked. Complacency may leave you unexpectedly exposed to significant negative implications.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
What is inflation risk and how does it affect me?
Simply put, inflation means that a good or a service costs more today than it used to in the past.
Remember when the average price at the pump was below $1 per gallon? The year was 1988, and it cost roughly 90 cents per gallon (the average Super Bowl advertisement at the time was $645,000, compared with $5 million this past February). Today, the national average for regular unleaded is $2.92. Of course, there are many forces at work that influence the price of gasoline, and Super Bowl advertisements for that matter. The takeaway is that accelerating inflation means higher prices for everyday goods and services. Think of gasoline, groceries, medicine, child care and college tuition.
The risk of inflation is that the growth of your personal income and retirement benefits may not keep up with the accelerating pace of rising prices. In fact, in today’s inflationary environment, your income is already likely being outpaced by approximately half of the items that comprise the typical U.S. consumer’s budget, according to the Bureau of Labor Statistics – BLS.
For example, the cost-of-living adjustment (COLA), which helps to offset inflation for Social Security benefit recipients, is not expected to keep pace with the projected price increases this year for many common goods and services. The 2018 Social Security COLA was +2.0%, which compares unfavorably to the BLS’ 2018 forecast of +11.1% for gasoline and +4.3% for airfares. The average college tuition and other associated costs have risen 8% over the past five years, while long-term care costs grew 4.5% in 2017. According to the National Association of State Retirement Administrators, many state-sponsored pension plans have reduced COLA benefits for newly hired employees since the 2008/2009 financial crisis, and over 25% of current plans do not even provide a COLA.
While you may not “feel” the dynamics of inflation on a daily basis (picture cringing at the thought of “surge pricing” from ridesharing providers like Uber or Lyft), over time, the compounding nature of inflation can erode your wealth. For example, let’s say you are 30 years away from retirement, and you estimate you’ll need $1 million to comfortably support your lifestyle needs. Assuming annual inflation of +2.5% (similar to this year’s forecast), you’ll actually need approximately $2.1 million in 30 years to equal what $1 million is worth today. That is the real-life impact of inflation.
Why is inflation forecast to pick up?
Looking forward, inflation, as measured by the Consumer Price Index (CPI), is expected to accelerate from lower levels now to +2.4% by year’s end. Headline inflation — a measure of total inflation, including food and energy prices, which tend to be much more volatile — is forecast to pick up this year for a multitude of reasons. The growth outlook for the U.S. economy remains solid (more growth equates to more consumer spending, and higher prices), trade policies may weigh on imports (also leading to higher prices) and the recent corporate income tax reforms could spur business spending activity.
Your personal inflation gauge may be higher or lower than the headline rate, depending on your lifestyle and spending needs. For example, if you enjoy cooking at home, your food cost inflation will be approximately +0.4% this year, compared to +2.5% if you prefer to go out to eat more often. The point being that inflation is relative.
What can I do about the risk of inflation to my portfolio?
There are several investment strategies that one could employ to prepare their portfolio for an inflation pickup, many of which leverage some form of built-in purchasing power protection.
- Real asset exposures (global real estate, global infrastructure and commodities) can provide inflation protection over the long term; however, one must be mindful that all strategies are subject to volatility and changing conditions during short periods of time. Global real estate property values tend to rise as the economy improves, and global infrastructure exposures with contractual provisions typically allow utility providers to pass through higher prices to consumers (think of turnpike tolls increasing).
- Diversified commodity prices, such as gold and oil, may also appreciate as their prices tend to rise with inflation. Again, these types of investments may protect against longer-term inflation, but they are also subject to volatility and other risks unique to their assets classes.
- Depending on your specific goals, minimizing direct exposures to longer-term fixed income allocations (bonds) may also help during times of rising inflation and interest rates. As interest rates rise, a strategy employing longer-term, lower-yielding bonds may face more headwinds than a portfolio made up of shorter-term, higher-yielding bonds. For example, if interest rates rise 1%, a 30-year Treasury bond may fall by a greater percentage compared with a 5-year Treasury note. This is due to the duration (or sensitivity) of bonds to changes in interest rates; longer-term bonds tend to be more sensitive.
- Cash-alternative money market funds are another consideration, as the purchasing power of cash can easily be eroded by inflation. Money market funds are very short-term investment options, and increases in underlying interest rates may impact their yields quicker.
- Additionally, one could look at creating a laddered bond portfolio. Such a portfolio spreads bonds over short (one- to two-year) to long (eight- to 10-year) maturities. As the earlier bonds mature they are reinvested into longer bonds as interest rates rise. All of this needs to be evaluated within the construct of an overall allocation with consideration to the specifics of one’s personal circumstances.
Integrated with a careful review of your short-term cash-flow needs and spending habits, you should be able to implement an investment approach that will hedge against inflation erosion. The key is devising a strategy that supports your long-terms goals while putting you in position to defend your assets from the threat on the horizon.