Note: This article is intended to provide our perspective on rising inflation and surging oil prices. We continue to closely monitor the situation in Ukraine, and our thoughts are with all those impacted by this crisis. To support on the ground relief efforts in Ukraine, our organization, through Great-West Lifeco, will contribute $200,000 to the Canadian Red Cross as part of the Ukraine Humanitarian Crisis Appeal.
For over a decade, U.S. inflation wandered lazily within a 0% to 3% range. Few people thought much about it. Then, about a year ago, with the world awash in money printed during the pandemic, reopening began accelerating, supply chain issues arose, and prices started rising. Inflation began a steady upward trajectory and has since climbed to around 8% on an annualized basis.
Russia’s war on Ukraine has exacerbated the situation, driving oil and other commodities prices higher. With the average national gasoline price now well over $4 per gallon, inflation is center stage. When things cost more, our money is worth less, and we all feel the impact. Our perspective is to expect inflation to remain elevated and possibly accelerate in the short term. Try not to overreact.
We see a few key factors why inflation may exceed double digits for the first time since 1981.
- Energy and other commodity prices have recently spiked. Russia is likely to remain isolated from the global economy for the foreseeable future so this may take time to revert.
- The Case Shiller National Home Prices Index rose 18.8% last year, the most since the index began in 1987. Rental prices are a big part of official inflation, and rent increases tend to lag home prices.
- China’s aggressive approach to containing Covid could prove inflationary or deflationary. It is likely to exacerbate supply chain issues.
Recent Fed Rate Increases
The Fed first acknowledged inflation as more than a “transitory” threat just about four months ago. Rate hikes have now begun, though with equity and bond markets down, they may continue in a somewhat measured manner rather than a brisker pace which would be expected if the sole focus was inflation. The central bank’s job is balancing inflation and the labor market. This is a very difficult task, but it appears likely that history will remember the Fed acting too late and too slow in curbing inflation, in this case.
Still, we expect inflation to moderate over the next few years:
- In addition to the Fed (and other central banks), the federal government seems to be getting the hint, as evidenced by the challenges the Biden administration is facing in passing another major spending package. The record pace of government spending may decelerate as a result.
- Our belief is the supply chain issues causing pricing pressure will abate over time, relieving one inflationary pressure point that exists today.
- Innovation and technology continue to drive efficiencies and promote downward pricing pressure.
Booms and busts in oil prices are nothing new. Oil will remain volatile and may spike higher, but we predict it will gravitate back toward the $60 range over the next couple of years. That level is a little above the price to produce U.S. shale supply, which is the biggest variable in global output. It can make up for Russia’s share in the increasingly likely event it remains isolated from the global economy.
Oil drilling in the U.S. has become very unpopular in recent years. Energy companies were encouraged to return available capital to shareholders instead of new drilling, and new capital had become hard to come by. With profits to be had, we expect that will change. Add political pressure due to the price at the pumps, and especially if oil supply becomes considered a national security issue, U.S.-based supply may ramp up more quickly than we have ever seen.
Meanwhile, consumption is now exceeding pre-pandemic levels and is predicted to continue to rise. However, every day the number of electric vehicles on the road increases and the pace is accelerating. The spike in oil prices is accelerating investment in other clean energy alternatives. Fossil fuels will continue to be the primary source of power for the world for years to come, but supply and demand trends are likely to support a lower price of equilibrium.
What Can I Do?
High inflation is bad for most people and managing it as an individual can be confusing.
How one is invested can be important. What worked the last ten years, when inflation and interest rates were very low, may not work now.
There is no silver bullet. We believe the following factors are likely to help:
- Maintaining a global approach
- Avoiding over concentration to growth stocks
- Allocation to inflation protected bonds
- Having exposure to real assets
This is how we design portfolios for our clients at Personal Capital. Many high-priced growth stocks have been decimated in recent quarters, and those concentrated in this area remain at higher risk in our view. Companies whose earnings are expected to come far in the future are generally worth less now if interest rates and inflation rise.
Beyond investing, there are actions that can be considered, but we urge people not to panic or overreact. Barring hyperinflation like Russia is likely about to experience, the impact of inflation plays out relatively slowly and not all at once.
Markets are likely to remain volatile, but cash is all but guaranteed to lose value to inflation. This means you should reevaluate holding extra cash beyond your typical emergency fund levels.
We do not believe retirement plans need to be radically changed. Those closer to retirement may look more closely and consider adding to reserves. Our Retirement Planner has a default inflation rate of 3.5%. This has been a conservative stance for a long time but may no longer be. It still feels valid to us as a long-term assumption, but it can be instructive to play around by increasing it a percent or so to understand the potential impact. Notably, Social Security is designed to increase with inflation.
If it persists, higher inflation means we may have to consume a little less.
Unfortunately, we are reminded how uncertain life and the world are. For those who are able, now feels like the time to enjoy experiences with family and friends, and we will know more with time.
Thank you for being a reader of Daily Capital.