This edition of TGIF 2 Minutes originally ran on February 16, 2018 just after the (now) temporary 12% decline in the Dow Jones, which ended as a 6% decline for the month.
Typically, I do not get too far “into the weeds” of technical terms in my TGIF 2 Minutes messages. However – this has not been a typical last two weeks in the markets – at least not “typical” as defined by the past several years of gradually UP markets (and portfolios) month after month. Thus, a short walk into the weeds to talk a little about inflation is warranted – and may shed light on the volatility we have experienced lately with more likely to come over the next months and year or so.
See this visual of a rocket launch* – and not just any rocket launch, the Falcon Heavy launch as photographed by a friend of mine with years of clearance for NASA rocket launches – as an appropriate comparison to what inflation can look like.
Inflation – at least in the way economists and stock and bond markets measure it – has largely NOT been present in the past several years. This does not mean that the cost of college education, certain foods and air travel have not gone up – they have. But in the way economists and finance people look at inflation, it has been low, even alarmingly low, for some time. Markets do not like uncertainty, let alone alarm!
The presence of inflation – prices going UP, UP – indicates several things. [update 10/5/2018: Since February 2018, the Federal Reserve has raised interest rates 3 times partly to combat inflation in the US economy.]
First, and most basic, with inflation your money today is worth LESS tomorrow and down the line. That is why the “mattress comparison” is often used: if you stuff your cash under your mattress (or simply in a bank account) today or for several or more years, you will NOT be able to purchase the same amount of products and services when you take the cash out at a later point. Not good. This is the basic concept of falling “purchasing power” of money. This fact is also one of the most basic reasons individuals and companies invest their cash and savings in things like stocks, bonds, real estate, gold, commodities and the like – with guidance, to allow savings to keep up with inflation.
Inflation also can indicate a relatively strong economy – which can sometimes progress into an over-heating economy. But net-net inflation early on often indicates a strong economy. The US has only recently begun to show signs of a growing economy after nearly 10 years of lack of growth, as measured by GDP (Gross Domestic Product, or the total goods and services produced in an economy in a year).
To the stock and bond markets, inflation affects things mostly negatively, but can indicate strength and be OK (just OK for a time) for stocks:
- For Bonds, inflation is the ultimate enemy. The fixed interest you receive on your bonds and CDs is NOT as valuable tomorrow as today. If prices are going up – or even thought to be going up soon like now in the markets – your purchasing power declines and thus bond prices decline (sometimes pretty quickly). Bond prices declining means, by definition, their interest rates have gone up.
- For Stocks, when bond yields increase, stocks’ first move is usually DOWN until the markets figure out a relative balance between interest rates, expected inflation, economic growth, dividends and stock prices. This explanation is greatly simplified financial economics but enough to shed light on why your stock portfolio has and will see losses from time to time in the midst of this process. [update: 10/5/2018: When interest rates rise, stocks can tend to go DOWN when investors see they can invest in bonds and earn a higher interest rate than the average stock dividend rate.] Please ask me about this.
The last two weeks have seen reports come out about recent UPWARD moves in wages and inflation. Last month’s increase in the measure of inflation was driven by higher prices for gasoline, shelter costs such as rent, medical care, food and clothing. Long story short, inflation is beginning to become present and the markets are reacting. Advice on asset allocation and rebalancing are key for investors at this time.
*Credit: Jared Haworth; SEE ALL at https://wehadtoday.com/jared/falcon-heavy/ Prints available.