'Everything Screams Inflation’ - How to Interpret the Headlines

3 Oct 2022

How quickly things change.

Two years ago, the New York Times reported, “Federal Reserve offcials are increasingly worried that infation is too low and could leave the central bank with less room to maneuver in an economic downturn.”1 More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors: “Everything Screams Infation.” The author, a veteran fnancial columnist, observed, “We could be at a generational turning point for fnance. Politics, economics, international relations, demography and labor are all shifting to supporting infation.”2

Is infation headed higher? In the short term, it has already moved that way. With many frms now reporting strong demand for goods and services following the swift collapse in business activity last year, prices are rising—sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines are once again enjoying fully booked fights, and many restaurants are struggling to hire cooks and waiters. We should not be surprised that airfares and steak dinners cost more than they did a year ago. Or that stock prices for JetBlue Airways and The Cheesecake Factory surged over 150% from their lows in the spring of 2020.3

Do such price increases signal a coming wave of broad and persistent infation or just a temporary snapback following the unusually sharp economic downturn in 2020? We simply don’t know. But future infation is just one of many factors that investors take into account. The market’s job is to take positive information, such as exciting new products, substantial sales gains, and dividend increases, and balance it against negative information, like falling profts, wars, and natural disasters, to arrive at a price every day that both buyers and sellers deem fair.

Let us assume for the moment that rising infation persists into the future. Some investors might want to hedge against higher infation, while others might see it as a markettiming signal and make changes to their investment portfolios. But for the market timers to do so successfully, they would need a trading rule that directs exactly when and how to revise the portfolio—“I’ll know it when I see it” is not a strategy. A trading rule based on infation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.

It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding infation (or anything else). Current prices already refect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat. 

The evidence of success in pursuing such timing strategies—by individuals and professionals alike—is conspicuous by its absence.

To illustrate the problem, imagine it’s New Year’s Day 1979. The broad US stock market4  produced a positive return in 1978 but failed to keep pace with infation for the second year in a row. Your crystal ball informs you that the next two years will see back-to-back double-digit infation for the frst time since World War I.

What would you do? You have painful memories of 1974, when the infation-adjusted total return for US stocks was –35.05%, among the fve worst returns in data going back to 1926.

We suspect many investors would sell stocks in anticipation of signifcantly lower security prices over the subsequent two years. The result? Most likely a failure to capture above average returns from both the equity and size dimensions, as shown in Exhibit 1.

Some of the recent concern regarding infation appears linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimize its importance. But the news items in Exhibit 2 suggest these concerns are not new, and the expected consequences of these issues are likely already refected in current prices. The future is always uncertain. But as economist Frank Knight observed 100 years ago, willingness to bear uncertainty is the key reason investors have the opportunity for proft.6 Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future. And we’re here to help!  

To find out more, please don’t hesitate to contact us to discuss.

The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.

Source: Wellington, W. (2021). ‘Everything Screams Inflation.’ How to Interpret the Headlines. [online] Dimensional. Available at: https://my.dimensional.com/everything-screams-inflation-how-to-interpret-the-headlines 

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