Episode: 04-12-2022 | Inflation And What To Do About It

Hosted by Kevin J. Zywna, CFP® and Allison K. Dubreuil, CFP® Dollars & Common Sense · Inflation & What to DO About it Inflation – Current & Historic Perspective That reading just came out today. In February, Consumer Price Index was up 7.9% And then January 7.5%. So these are very recent and dramatic shifts […]

Hosted by Kevin J. Zywna, CFP® and Allison K. Dubreuil, CFP®

Inflation – Current & Historic Perspective

That reading just came out today. In February, Consumer Price Index was up 7.9% And then January 7.5%. So these are very recent and dramatic shifts in the rate of inflation over the last few months. Now I want to put some of this in context.  I know there’ll be a lot of hand wrangling and teeth gnashing about the higher inflation levels. I will say this – we’ve had a good run, we’ve had a real good run. The long-term average inflation rate as measured by the consumer price index for the last 50 years has been about 3.9% per year. On average, you go back the last 100 years, that CPI average annual number goes down to about 3.1%. So somewhere between 3 and 4% is about the average long-term, amount of price inflation we tend to see on any given year. Well, we haven’t seen even 3% for about the last 30 years. You’d have to go back to about 1992. Before the Consumer Price Index and inflation was above 3% for any significant length of time. We have ticked up above three on a couple of occasions in the last 30 years, but it hasn’t lasted very long. So these readings are the highest it’s been in the last 30 years.

And if they remain a short-term trend, then this is nothing to be overly concerned about. It’s obviously not pleasurable to deal with. it causes a fair amount of the goods and services that we all purchase, to go up in price. Which means more of our pay is going to groceries and bills and gas and other things, than maybe into our savings account or for things that bring us joy and pleasure in life. So it is something to be to keep an eye on. But it is not something to be overly concerned with at this point. I know a lot of news media outlets will make a big deal out of this. Again, it is something to keep an eye on but not something to be overly concerned with yet. Because for the last 30 years, the inflation rate in the United States has been consistently below its long-term trend of 3%.

Is Inflation Bad?

We’ve had a pretty good run from an inflation standpoint. I should make the overall general comment too – some inflation, a little inflation is good, natural, and healthy. Too much, too soon, inflation can be disruptive to the marketplace, to the stock market, to companies and to the individuals. We’re not there yet. We’ve got a ways to go. But some level of inflation price increases is good, normal and natural. It nudges people to purchase things today, instead of putting off that purchase, say two or three years, when they know it’s going to be a little bit more expensive. And that’s generally good and healthy in a consumer-oriented society. What you don’t want really is deflation. Prices declining too soon, too quickly. Because then people hold off on their purchases. then they say, “well, if it’s cheaper this week, it’s just going to be that much cheaper next month. And if it’s going to be cheaper next month, it’s going to be cheaper next year, so I’m just going to wait, then no.” And then the buying starts to dry up. That’s why deflation is a bigger concern than inflation. It’s exceptionally rare to really experience a major economy like ours, to have any sort of significant deflation to last any amount of time. So a little bit of inflation normal and healthy.

How To Prepare For Inflation’s Impact

The numbers are starting to tick up here in the last few months. I’m not going to get into so much of the how and the why and the reasons why it’s occurring. But I want to talk about some of the things that you can do to prepare for it, or to adjust to it if it continues at a more elevated rate right now. Then we’ll also discuss some of the effects of higher than average inflation. What that can do from an investment perspective, as well.

Some big headline news that came out today is that the Consumer Price Index was up 8.5% in March that was on the back of 7.9% in February and 7.5% in January. A long-term inflation trend ranges between three and 4%. So we are almost doubled long-term inflation trends over the last few months. But the prior 30 years has been below trend below 3%, virtually all that entire time. So having a little bit of near-term inflation, while not pleasant is also not the end of the world. So let’s talk about some of the things what you can do. What you should do about inflation and what you should not do about inflation. How you can manage your way through a higher inflationary environment.

Watch Out For Your Cash

So first of all, watch out for your cash. Cash is not king. In an elevated inflationary environment, the cash, by cash I mean that cash – it’s basically sitting in bank accounts, savings accounts, checking accounts, money markets, most CDs at this point in time. Any other type of special savings account that you have – bank assets. Bank assets are almost always prevailing rates on bank assets are almost always below prevailing inflation rates. So whatever money sits in the bank, for most period of time, is actually eroding its purchasing power a little bit over time, due to the fact that it’s not growing or earning as much as the current inflation rate.

Keep Your Cash Emergency Fund

Now, having some bank assets is necessary, vital and healthy in an overall financial plan. And we always talk about having an emergency fund and safe secure bank assets to serve as the financial foundation of a good financial plan. And that’s roughly defined as three to six months of your living expenses tucked away in a bank savings account, earning whatever current prevailing rates are. You’re not trying to squeeze another 10th percent of interest out of it. That’s not the purpose of that money. The purpose of that money is security, safety. And like the name implies, for only emergencies, it’s not for a new dress, or fancy sport coat, or a couch for the living room or trip to Cabo. It’s for when the car breaks down, or you have unforeseen medical expenses or tree falls through the house in your roof. Those are big, unforeseen expenses. That’s where your emergency fund comes in and allows you to sleep comfortably and safely at night knowing you got the bases covered. Now, one of the strategies we like to employ with our clients as they enter retirement is to essentially build their emergency fund up to even a higher level of savings. So where a person who’s in the accumulation phase is still working, still earning money – 3 to 6 months is typically good for most people to keep in the bank account.

Cash Funds During Retirement

When you get in retirement and you start living off of your nest egg and consuming your nest egg to support your lifestyle, that’s when we like to see a higher bank balance. So there we like to see sometimes up to 12 to 24 months. Anywhere between one to two years of living expenses tucked away in a bank account. And there, if you go up to the higher ends of that, that’s where some of that money could be put into a CD for like a 12 month CD, six months CD, maybe 18 months CD. You can try to eke out a little bit more return on that type of money if you’re going to keep that high balance. The reason why we like our retirees to keep a higher balance like that is because of times the portfolio goes through an inevitable pullback, because the market pulls back. If that pullback is steep enough, deep enough, takes long, too long to recover. Then we can reduce the amount of the portfolio withdrawals. You purposefully draw down from your bank account and your lifestyle is completely protected. You don’t have to worry about what the markets are doing in the short term and your lifestyle is never impacted. Yet you benefit from long-term growth of keeping the money invested in growth type of assets. Beyond those parameters that’s how much you should keep in bank assets from a financial planning perspective.

Can You Over-Fund Bank Assets?

Now, there definitely can be some psychological reasons. And we have plenty of clients who like to keep even more than that in their bank. And we don’t arm wrestle that too much. Because it’s a very personal thing, how much money stays in the bank, despite what the analysis and the numbers say. But keeping too much money in the bank is not good for your overall financial health. Because too much in the bank means that it’s not keeping pace with inflation, its purchasing power is being eroded. And while it doesn’t fluctuate in value in the bank, you are losing money a little bit every year, especially if you’re only earning point 1% on your savings rate, and inflation is now trucking along at seven, or 8%, annualized per year. So now you’re really falling behind to the effects of inflation. And that’s why you don’t want to over fund bank account assets, savings accounts, CDs. You’re always going to be falling that much further behind.

Inflation And Interest Rates

And while it is true, as inflation picks up, typically, for a variety of reasons, interest rates will also rise. We’re seeing that happen. The rise in interest rates typically is much slower and lags the rates of inflation. Then by the time it trickles down to your actual financial institution and your actual type of checking account or savings account or CD that you have at the bank, there’s a big lag in there before you start to feel those prevailing interest rates in your savings rates. So that’s why you don’t want to keep too much money in the bank beyond the amounts that are necessary and safe for a comfortable lifestyle.

The Individual Impact Of Inflation Varies

Another thing to be aware of when it comes to inflation is that inflation is very personal. One person can be more impacted by the rising prices of goods and services, then another depending on the types of goods and services that one consumes. If you can be somewhat flexible, have the ability to be flexible in your buying patterns, then sometimes you can navigate your way through an inflationary rising price environment, and not be as impacted as some other people.

For example, some of this is natural to me, if people are their 20s, and just starting out in the workforce, typically, because they’re younger, they are also healthier. The above average rates of inflation in the healthcare system typically does not impact them too much, if at all, because they rarely seek medical services, except for routine.

On the other end of the spectrum, if you’re in your 80s, then the rising costs of health care is a big concern. They tend to consume more health care once we get older and later in life. The fact that inflation is personal means it will affect each one of us differently.

For example, when it comes to the price of gas – tends to hit most people. With the practical application of electric vehicles, we’re finding out that some people don’t have to pay $1 for gas. If you have 100% electric or even if you have a hybrid, you’re certainly reducing your gas intake. So if gas is for $4.50 a gallon, it doesn’t impact your lifestyle much at all. If you’re plugging in either at home or at a public charging station, there’s plenty of them around town now in Hampton Roads, where you can charge for free or no additional cost. So being able to adapt your spending patterns and your lifestyle to what’s happening in the economy and the types of goods and services that are seeing the most inflation allows you to navigate your way through it a little bit easier. The one area most of us can’t get away from too much is the grocery store.

Inflation Discussion Recap

Tonight we’re talking about inflation, and what you can do about inflation, if it continues to remain elevated for an extended period of time. Inflation numbers for marshes came in at 8.5%. That’s over double, long-term inflationary trend. The last few months have been consistent with that. But prior to the last several months, we had a really good run the prior 30 years, was below average inflation growth.

When you think about it, over the last 30 years, when did you really start becoming aware of finances, the economy inflation? Probably 20s, right? When you either graduated from high school and got a job or graduate from college and got a job. So really, for people who are about age 50 or younger, they’ve never really even seen an elevated inflationary environment. We certainly have plenty of clients who can recount buying homes with mortgages that were 15-16% at one time in the late 70s, early 80s timeframe. Now that just sounds otherworldly. Today, where mortgages at one time not too long ago, like a year or two ago, you get a mortgage in the twos, 2%.

Now we’re in a more normalized range of 4%, sometimes a little bit over 5%. Still good rates. Still historically great mortgage about borrowing rates. Can you imagine buying a house with a 15% mortgage? I mean, the amount of house that you could afford is probably a third of what most people are living in today. So we had a really good run for inflation.

If we are starting to see it tick up substantially, for a period of time, then there’s some things you can do to try to protect yourself. Don’t keep too much in the bank, keep your emergency fund in there. That’s for sure. That’s necessary and needed. But don’t keep more than your emergency fund in there. You put in higher earning assets, and I’ll get to what some of those are later on, then, you want to make sure that you keep an eye on your spending patterns.

Inflation is very personal. Price, raising prices in some goods and services do not affect other people who don’t consume as many of those rising goods and services prices, as others. So if you can adapt your lifestyle somewhat, you can better navigate your way through rising inflation.

And then thirdly, don’t shy away from investing. There is this idea that rising inflation too soon too fast…when talking about inflation, a little is normal and natural and healthy. Too much too soon is disruptive. We’re starting to see some of that develop now. So it can be disruptive.

And there’s this idea that rising inflation is automatically going to be bad for the stock market or for investing in equities. That is not necessarily the case. Profitability is still the biggest driver of stock performance over the mid to long term. In the short term, day to day, the stock market is like a longtail cat in a roomful rocking chairs. I mean, anything can happen anywhere on the planet, and the stock market can react on a daily basis. Similarly on a weekly or monthly basis. But once you start stretching out your hold period, two years, three to five years and beyond. Then it’s really the profitability of the company that has most to do with how its stock price typically performs.

How Companies Can Adjust To Inflation

What companies can do in an inflationary environment is they have the ability to combat, to a certain degree, rising prices for the goods and services that imply that they input to produce whatever goods and services. They output their raw materials. That is something they turn into an end product. So companies have the ability to adjust pricing on their goods and services, obviously, that can mean raise them to combat, the raising of their inputs. They can negotiate with suppliers, they can buy in bulk. If they see they think inflation is going to be with us for a while, instead of placing an order for say six months, every six months, maybe they place an order for two years. And they lock in current prices for two years instead of six months. So that means they can typically lower their overall cost of production. So raising some prices on their goods and services, they output as well as trying to control costs on the inputs, is a way that companies have the ability to adapt to inflation and maintain in maybe not in the short run maybe not on a quarterly basis. But on a medium-term basis on an annualized basis, they have the ability to combat inflation and maintain their property profitability levels. Or in some cases, increase them. So the idea that inflation has to be bad for investing in the stock market is not true. And if time permits, I’ll get into some of the specifics for that.

Inflation And Investing In Bonds

Allison Dubreuil, Wealthway Financial:  We have experienced this with several clients recently where they

The other thing I want to talk about as it relates to investing is what inflation does to the investments in bonds, which are a classic and typical part of most investor’s portfolio. Inflation will have the effect of driving up interest rates on prevailing savings instruments like: savings accounts, and on new bonds that get issued by the government or by companies. As prices increase, as people start to see prices increase, they aren’t willing to buy your General Motors two year bond that is only paying 2%. They’re like, well forget that 2%, that’ll be gone in no time. I’m not going to buy that. So then GE General Motors has to issue a bond, say paying 4%. Oh, okay, that’s a little bit more attractive. So rising inflation will cause (through a confluence of a variety of factors), rising interest rates.

Rising interest rates are the nemesis of the bond holder, because interest rates and bond values act like a seesaw. As interest rates rise, the value of prevailing already issued bonds decline. Because if I got bonds, back the example, they’re only paying out one or 2% per year, well, there’s new bonds being issued over here at four or 5%. Well, if I have to sell my lower yielding bonds, that I get to sell them for a discount, because no one wants one or two bonds unless I give them a deal. So it causes rising interest rates, forces the values of prevailing bonds and bond funds, bond mutual funds ETFs, downward.

So you’ll still get your income. You still get the payments, the interest that come from bonds. But it’s going to be at a lower level than new or current bonds that are being issued. That will drive down the value of bond holding, individual bonds, bond funds, and ETFs.

And we’ve been banging this drum now for at least the last five years, maybe closer to 10, that bonds are not going to be the diversifier from stocks, that they traditionally were 30 years ago. They’re not going to be that way today. Because we’ve been in such a low interest rate environment for about the last 10 years. As we’re starting to see rates rise, bond values are going to go down. We’re starting to see that that means people who are very bond heavy in their investment portfolios are going to have a harder go of it to gain growth. We think in the next say, one to three years, and so for a while now, we have been reducing or eliminating the amount of bond holdings in our client portfolios. This being one of the reasons, there’s a couple other ones, but this being a main one – when we’re in an already low interest rate environment, rates – while they can stay low for a while, and they did, bonds can survive in that environment and be okay. But once they start to rise, bond values decline. They aren’t the diversifier from stocks that people think they are in a rising interest rate environment. So what once used to be considered the traditional retirement asset allocation 60% stocks 40% bonds, we’ve been saying for years now that is an old antiquated thinking in this environment. If you’re holding that high percentage of bonds in your portfolio, you probably want to adjust your rate of return expectations going forward at least, here in the near term, because bond values are starting to decline.

Inflation Discussion Recap

I talked about inflation – where we are and historically. What you can do about it to help fight the effects of inflation. We talked about investing, how investing is not something to shy away from due to inflationary reasons, except perhaps the component of your investment portfolio that is in bonds. Because bonds are hypersensitive to changes in interest rates. Inflation tends to drive up interest rates, which has the corresponding effect of driving down bond values. And so you might want to consider lowering or reducing the amount of bond exposure you have in your investment portfolio.

One of the reasons that people, in addition to as a hedge or as a complement to equity investing, help moderate the swings, the big short-term swings of the equity market, a lot of people invest in bonds for income purposes. Because bonds pay a coupon or an interest charge. Some pay monthly, some pay quarterly, some pay annually. Some don’t pay it at all, it’s built into the price of the bond. The conversation gets a little bit more complex after that point. But bonds pay interest. People use interest to spend money to pay the mortgage and the car payment and buy groceries with and gift to their grandkids. So the incomes – a lot of people buy bonds for income purposes to supplement their lifestyle.

This is a common fallacy that we hear from a lot of people, you don’t need income producing investments in order to have income from your investments. Okay, so you don’t have to invest in bonds because they pay interest. You don’t have to invest in large established S&P 500 companies because they pay a dividend. That’s nice, and we’ll take it. But you don’t have to invest for income in order to have income from your portfolio.

That’s never been more true than nowadays, where transaction costs of buying and selling stocks, mutual funds. ETFs has essentially gone to almost zero. It’s very negligible for most of the major providers that Schwab, TD, Ameritrade, Fidelity, Vanguard, other big brokerage houses, the trading fees have gone to almost zero.

So philosophically, from our professional point of view, we have our clients invested primarily for growth. And then we shave off shares of XYZ mutual fund or ETF exchange traded fund. We shave off shares to produce the income they need to spend. Invest for growth. Sell as needed to provide the income you need to live your life. You don’t have to invest in order to have income from your portfolio. That’s another sort of antiquated notion that still hangs around today. The benefits of doing that is that you gain the higher long run rates of return associated with equities, with stocks, instead of bonds. Bonds are traditionally about two-thirds to a half less than what long run rates of return are from equity. So I understand why people use bonds. But you’re going to have to be careful in this rising interest rate inflationary environment.

Finally, in order to wrap things up here, a little historical perspective on what has happened over the last several rate hikes that we have seen from the Federal Reserve. Without getting into all the technicalities and the complexities of why the Federal Reserve raises or lowers short term interest rates. By the way, they don’t control all the interest rates. They don’t control your bank savings account interest rate. They don’t control the rates on corporate bonds. They don’t even control the rates on government bonds, once they’re released into the marketplace. A lot of that is all market determined. They do control the interbank lending interest rate called the Fed funds rate, which then does have a ripple effect throughout the economy. So to just clear up that misconception, the Fed does not control all interest rates – just a few key interest rates that do have some impact. So the Fed tightens the money supply or when they raise interest rates, and they do that usually to cool off a heated economy. There have been seven rate hike cycles over the last 44 years. Seven periods including the one we’re in right now. And over those last seven periods of the last 44 years, about one every six years we’ve had a raising environment. Only two of those years were the performance of the S&P 500 negative. Even there, it was slightly negative, five were positive. That’s why raising rates isn’t necessarily bad for your investments.

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