PWL Capital September 28, 2021 Personal Wealth Is inflation embedded and should investors care? Inflation in Canada rose 4.1% in August, on a year over year basis. A year ago, inflation was 0.5%. Inflation is of concern to investors who plan to spend their investments in the future, which is most of us. Consider an investor who expects his portfolio to grow by 5% annually over the next 10 years. An initial investment of $100,000 would grow to $162,889 after 10 years. Suppose the price of goods also grew by 5% annually over the same period. Despite having more money, the investor’s purchasing power would not have increased. Investor returns calculated net of inflation are called real returns or inflation adjusted returns. When planning over a decade or more, assumptions about the value of future or expected inflation can make a big impact on your future purchasing power. This is of particular concern to retirees who cannot increase savings to compensate for any erosion of purchasing power. The question arises whether recent rises in inflation are likely to persist or fade away. The view that recent inflation is transitory is supported by recent statements by Jerome Powell, the Chair of the US Federal reserve, and most central bankers. The argument (Krugman, New York Times) is that the current spurt in inflation is due to supply and demand mismatches as productive capacity and consumer demand adjust after the shock of the COVID-19 shutdown. Embedded inflation was a term that arose in the 1970s when high inflation persisted for several years, and multi-year wage agreements incorporated future inflation. By 1980 inflation had risen to 13.5% and the Federal Reserve raised interest rates to a peak of 20%[1] to squeeze out embedded inflation. Businesses failed in large numbers and unemployment rose above 10%. Those that view current inflation as transitory point to the 1980s as a poor model for the present day, pointing out that the power of labour to organize has declined since the 1970s and that there is no indication of wage inflation. Others are less sanguine and the economic debate about expected inflation has spilled over to the political domain. Larry Summers, a former US Treasury Secretary under Bill Clinton, has criticized recent US government spending plans as irresponsible. The backdrop to some of this caution is that a massive increase in money supply has not led to increased inflation as many predicted. Financial historian, Adam Tooze, talks about economists being in a “gray zone”, lacking historical precedent for the current low interest rate economy. Investor response The relationship between inflation and investment returns can be looked at in different ways. There are several assets (E.g. stock, bonds, real estate and commodities) to be considered and a linkage can be sought between inflation and returns in the same year or in subsequent years. A further complication is that inflation can be considered expected (embedded) or unexpected. A recent study looked at all these possible relationships over the period 1927-2020. The authors found that most investment assets had positive average real returns irrespective of the value of inflation. The only assets that showed a positive correlation with expected or unexpected inflation were energy stocks and commodities but that these two assets had the downside of high volatility. Inflation-indexed bonds are an option for investors highly sensitive to inflation but even these come at a cost; the bond holder who forgoes inflation-indexing can expect to earn an additional return for bearing the risk of unexpected inflation. The authors conclude “simply staying invested may by itself be an effective long-term solution to inflation concerns”. [1] Federal funds rate Share: Facebook Twitter LinkedIn Email