Show me where it hurts

As we begin a new year, I want to start with a few salient data points:

  • US GDP is at an all-time high of $23 trillion.
  • The S&P 500 is at near record highs near 4,700, an all-time high.
  • Housing prices are at record highs, as are retail sales.
  • US household net worth hits a new high of $150 trillion.
  • New business births are at near record highs at 440,000.
  • There are 10.4 million job openings and 4.4 million people are confident about quitting and finding a new job (non-farm departures in the US).
  • Hourly wages are up 4.8%, particularly for the lowest income brackets.
  • Borrowing rates are at their lowest (10-year Treasury bonds) at 1.58%.
  • Over the past 30 years, a 30-year mortgage has gone from 9.90% to 3.10%.

And yet, consumer sentiment fell from 100 in 2019 to 66.8. People are unhappy with the current state of the economy. Why has trust plummeted nearly 30% in two years?

  • COVID-related fears continue to be an issue for businesses and consumers.
  • Inflation is at 6.22%, the highest level in over 30 years ($100.00 in cash will only buy $93.78 in goods and services next year).
  • Supply chain disruptions lead to longer delays (so you pay more and wait longer). Companies are worried about labor shortages.

Even with a rising salary, people are feeling the inflation. From the cost of a can of soup to the price of gas, everything seems (and is) more expensive. At the start of 2020, gasoline was below $2.00 per gallon, and today it is above $3.00. This 15 gallon fill went from $30.00 to $45.00 in a hurry and without warning. Inflation puts a dent in household budgets and a psychological dent in attitudes. While the US economy may be booming, the smaller economy of household budgets and spending is suffering.

Steve Booren

The rise in inflation should come as no surprise. History and basic economics tell us that low interest rates tend to give way to higher inflation. With over a decade of the Federal Reserve manipulating interest rates to historic lows, the real surprise is that it has taken this long for inflation to show up. Remember, the Fed was actively chasing higher inflation for several years until COVID hit. Then they pumped 39% more cash into the economy as a “stimulus” without an offsetting increase in output. The result is more money chasing the same goods and services, causing higher prices: inflation.

A simple example illustrates this monetary phenomenon. If you have a saving of 10 apples and $10, the price of each apple is $1. When you have $14 in the economy for 10 apples, the price per apple goes up to $1.40. Increase the money supply by 39%, and inflation is the obvious result.

Inflation can also be caused when supply becomes constrained, whether intentionally (Keystone pipeline cancellation) or not (Suez Canal backlog), with the same amount of money chasing fewer goods and services, again leading to higher prices. Continuing our illustration, we have $10 chasing eight apples. How do we get out of this jam?

The typical response is to rebalance the equation: raise interest rates with the aim of moderating inflation. Mathematically this makes sense but doesn’t always work in the real world. The worst outcome is a high inflation environment unaffected by rising interest rates. This is how we end up with exorbitant mortgage rates similar to those of the 80s. Consumers feel the burden when everything becomes more expensive, including the cost of borrowing.

There is currently a silver lining to rising interest rates; borrowing costs are lower than the rate of inflation. Borrowing money at a rate below inflation means that every dollar you borrow today is repaid with “lower cost” dollars in the future. On a “real cost, real return” basis, your mortgage currently has a negative interest rate. This is great for borrowers for whom mortgage debt represents about 70% of total household debt. Indeed, their equity increases while their borrowing costs are negative. The problem is liquidity: you can’t easily spend the equity in your new home. Equity does not help when the price of goods and services increases faster than your income. The balance sheet may look good, but your wallet will feel empty.

How long is this likely to last? We don’t have the ability to accurately forecast (nor does anyone else). However, given some of the inflationary trends, I believe:

  • Supply and demand imbalances will resolve, as they always do. When demand exceeds supply, companies adapt to meet the market.
  • Innovation will continue to be a massively deflationary force, as it has been for decades.
  • Monetary policy will eventually change course. Sometimes too late, or too little. Eventually, the Fed gets its policy right, and sometimes after the damage has been done. Paul Volcker taught us this lesson by reducing the money supply and raising interest rates. It was painful, but it worked.

Inflation is a headwind that we all face, especially at the levels we are experiencing today. It doesn’t take many years for a 6% inflation rate to have a dramatic effect on a fixed income, whether in retirement or from an employer. A rising income is the only way to ensure that your lifestyle is not affected. A dividend-growing portfolio is one potential method of achieving this goal, and it is the one we favor. A rising income looks like a “nice to have”, but in reality, it is more of a “must have”, inflation reducing your purchasing power. Real inflation is here, and anyone can guess how long it will last. Make sure your plan meets your needs and if not, consider making the necessary adjustments to ensure your continued purchasing power.

Steve Booren is the founder of Prosperion Financial Advisors in Greenwood Village. He is the author of “Intelligent Investing: Your Guide to a Growing Retirement Income”. He was named by Forbes as the 2021 State’s Top Wealth Advisor and 2021 Barron’s Top Advisor by State. This column is not intended to provide specific investment advice or recommendations.

Comments are closed.