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Inflation: Still Heating Up

Peter Mallouk

President & CEO

Jonathan Clements

Director of Financial Education
August 02, 2021

Inflation continues to top investors’ worries. But is it transitory or here to stay? Creative Planning’s Peter Mallouk and Jonathan Clements discuss the different types of inflation, which can have long-term detrimental effects on your portfolio, and what you can do to help mitigate its effects.

Hosted by Creative Planning Director of Financial Education Jonathan Clements and President Peter Mallouk, Down the Middle takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!

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Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education at Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, President of the firm, and we are Down the Middle. Peter at two months ago on this podcast, we talked about inflation because that’s what everybody was talking about. Guess what? They’re still talking about inflation, perhaps even moreso because inflation keeps heating up. Over the 12 months through June, the Consumer Price Index rose 5.4%, the largest increase in 13 years. But basic question that we were tackling two months ago, we’re still tackling today. Is this jump in inflation transitory, or is it permanent? What’s your take, Peter?

Peter Mallouk: I think it’s both. And I think this is a very important topic. It’s not like us to revisit that topic so quickly, but it has such repercussions for investment decision-making and the way an individual, it translates to an individual in terms of what an individual wants is to make sure that they can meet their needs in the short run, the intermediate run, in the long run. And the biggest threat to an individual’s ability to meet their needs in the long run is inflation. If you get the pile of money you think you need to be retired, but what that pile of money can buy goes down – that’s the biggest threat to a long-term investor. So it’s worth spending some time on and revisiting. And I suspect this won’t be the last time. And when I’ve written about this and we’ve talked about this, there’s three important themes that are taking place all at once, and we’ll just break them down one at a time: transitory inflation, normal or high inflation, and then deflation.

So, when we look at transitory inflation, a lot of what the Fed is saying, the Federal Reserve is saying is, “Hey, yeah, there’s inflation. We don’t feel the need to do too much about it because we think it’s transitory.” Meaning what we’re seeing now is going to go away. COVID was like a blizzard. Everybody went inside, the blizzards over, everyone came outside, there’s all this sudden demand. There’s no supply that’s ready to go. There’re containers still in China that should be in the United States. Their lumberyards weren’t operating and so on. So you have all this demand coming out and it’s going to take a while for suppliers to meet the demand. And when that happens, prices will come back down and normalize. That’s the idea of transitory inflation. And we’re seeing that there’s examples like lumber’s down 40%, 50% from its high, as supply comes to meet demand, and as high prices diminished demand.

We’re also seeing housing markets showing signs of softening a little bit. So we’re starting to see some of this massive demand finally being met with some supply and logistical issues around world being worked out. When we look at the debate, the real debate is most of this permanent high inflation, because that’s really would be a really big fear to investors. And just yesterday, the Fed said in their committee meeting, they said, “As the committee reiterated in today’s policy statement with inflation, having run persistently below 2%, we will aim to achieve moderately above 2% for some time, so that inflation average is 2% over time and longer-term inflation expectations remain well anchored at 2%.” Now, I mean, people were laughing out loud when they heard that because nobody, very few people when you hear them talking, believe that inflation is going to normalize at 2% or that we’re anywhere near that today.

And if you look at what it costs to make a cake, that’s actually up over 5% right now. Now the Fed would have us believe that that’s transitory and maybe it is, maybe it isn’t. We don’t know how much of this is going to stick. How much of this is going to stick. But the Fed has done a lot to really encourage inflation. When you have rates very, very, very low, it makes it easier to buy a car. It makes it easier to buy a house. It makes it easier for a business owner to hire people and grow their business. All of these things are inflationary pressure that drive the prices of things up. People have more money to spend. Interestingly, on the last time we talked about this, I use the Chipotle bowl as an example. Because I like going to Chipotle.

And when you look at all the ingredients that go into one of those bowls, I said, look, if the price of everything that goes in those bowls goes up, then don’t be surprised when Chipotle finally says, “We’re going to raise prices, and see what happens.” And then you start to get permanent higher inflation. Interestingly, last week, Chipotle had a conference call and their, I think it was their CFO who said, “Hey, all the prices in our bowl, our burritos went up. We raised prices expecting we might get some resistance. We didn’t. It’s going really well. We might raise prices again.” So that gets passed on to the consumer, but it’s also reflected in the stock price.

The question is, how many times are they and everybody else going to do that? How long will all these prices go up? This is the uncertain part of the formula. The bond market, because people are willing to buy CDs and bonds for long periods of time that pay a low percentage, the bond market is telling us it expects high inflation to go away. No one would buy a five-year bond paying 2%, if they thought inflation was going to be 5%. No one would go to the bank and buy a five-year CD paying 2%, if they thought inflation was going to be 5%.

Jonathan: One of the indicators Peter just mentioned here that a lot of people look at is the difference between conventional Treasury bond yields and yields on inflation-indexed Treasury bonds. And, you know that indicator, looking at the gap between them, that had been increasing and people were saying, “Hey, that’s a sign that the bond market expects inflation in the years ahead.” Well now, in recent months that started to come down again, which seems to suggest the bond investors, who are always seen as the vigilantes of the financial markets, are actually relatively sanguine about the prospects for inflation and think that these various supply chain disruptions are going to go away and that a lot of this inflation will be transitory. And we better hope they’re right, because, as you indicated, inflation is a long-term investor’s, one of their worst enemies. Not as bad as deflation, which we want to avoid at all costs, right? Higher inflation is definitely a problem.

Peter: Right. You’re exactly right about the bond market and the bond market is very, very boring to talk about. No one likes to talk about the bond market, but the bond market is much, much larger than the stock market. There’s more trading that happens to the bond market in the first hour of a day than in the stock market all day. And the most sophisticated investors are perceived to be in the bond market and they’re calculating that this inflation’s transitory. It’s going to go away and we will come back down to normal inflation. They may be right, because despite all of the Fed’s efforts to create inflation, we have, we live in a deflationary environment. And that deflationary environment is created by two things; deflationary, meaning prices coming down. One is technology, and we’re living in the golden age of this. I mean the way our kids read in textbooks about the invention of fire and then the invention of the wheel and the Industrial Revolution. 1,000 years from now, they’re going to be pointing to these few decades as the revolution of technology, artificial intelligence, and everything else.

This is pushing prices down. I mean, we’re watching, we have a library of 20,000 movies that cost less per month than going to one movie. We have a phone that replaces 50 different devices. We have a laptop that does more today than it did 10 years ago, and it costs less. We have a TV that’s bigger and brighter and looks better today than we did 10 years ago, and it costs less. That’s part of what creates deflation. And the second part is globalization. We used to, if we needed somebody to help prepare tax returns, do the back office work, or be a customer service center, we had to pay people in the United States to do that. Now it goes to China. When China gets too expensive, it goes to India. When that gets too expensive, it goes somewhere else. That’s globalization.

So, globalization and technology are deflationary forces. And I think those are really giving the Fed a free pass to be able to have all of these policies. So what would normally create high, permanent inflation, they might get away with it. And the bond market might be right. And the Federal Reserve might be right, that we settle back in to just normal inflation. But I will say this about normal inflation, normal inflation still really erodes the value of the dollar. Normal inflation is just a few percentage points a year, but it adds up over time. If we go back 100 years, I know that’s a long time, but if we just go back a hundred years, for perspective, the dollar has lost over 90% of its purchasing power over that period of time. So you have to do things over a multi-decade process. If you’re 60, you’ve got a 30-year time horizon. So you have to do things to be able to keep up with and stay ahead of inflation.

Jonathan: And as we talked before Peter, investing in the stock market is a great way to keep ahead of inflation because inflation drives up corporate earnings. Companies are being able to take those rising price of raw materials, the rising cost of labor and pass it along to consumers so that earnings increase faster than inflation. But inflation, whether it’s 2% a year or it’s 3% a year, which is what we’ve seen over the long-term average, whatever that number is, it’s a major problem for anybody who’s an investor in bonds or in cash investments. And even today, if you look at where inflation is and you look at what bonds are yielding, you look what cash investments are yielding, in many cases, people are not going to make money once inflation and taxes are figured in. They are going to see the purchasing power of their savings depreciate. So for them, whatever happens here with inflation is going to be a major problem. So, what do you say to people? You know, they’ve got a lot of money in cash investments. They got a lot of money in the bond market. What should they do about that?

Peter: Our philosophy at Creative Planning has been the same from the beginning to today, which is that owning things is the way to build and actually even to protect wealth, whether that’s stocks or real estate or whatever, income-producing things. And so you should have in cash what you need for an emergency reserve. That’s different for different people. Some people don’t need any emergency reserve. They can borrow against their investment account if they need to. Some people better have six months emergency reserve or more. You should have in bonds what will cover your needs in the event of an economic crisis, which could happen for any reason. It doesn’t matter what we’re talking about today. A major cyberattack tomorrow, the stock market can go down 50%. You always have to have enough in bonds to cover your needs, to get through a bear market like that.

Everything else, you should be an owner, to protect yourself and your future purchasing power against inflation. And that is the way investors should be postured, and moreso now in this environment. Used to, as an investor, get away with it and say, “You know what? I’m not going to do that. I don’t like volatility. I’m going to have 50% or 40% of my money in bonds.” Well, if you’re using a high-single-digit rate of return in your projections, you can throw that out the window if a lot of your portfolio is in bonds. 80% of bonds pay less than 2%. It’s the lowest it’s ever been in history. The math doesn’t work for most Americans. You’ve got to engage the portfolio to succeed.

Jonathan: So, in terms of that cash and bond number, I guess there are probably three things that people should be thinking about. One is how much money they might need for financial emergency, especially if they’re in the workforce and they find themselves out of work. Second, if you’re a retiree, you want to have enough in bonds and cash investments to cover your spending needs for maybe five years in case the stock market falls out of bed, and so you have time for the market recover. And then I guess on top of that, we have to think about personal risk tolerance. Some people are going to want to have more than that simply because they find it nerve-wracking to own volatile investments, meaning owning stocks. So those are the three key components here. Right, Peter?

Peter: That’s exactly right.

Jonathan: So, before we go to the tip of the month, I just have one question for you, given that you’re playing supply chain disruption guru here. When am I going to be able to get a reservation at a decent restaurant? I tell you, every time I try to make a reservation, it’s like, you can come and eat at 8:30 at night.

Peter: Yeah, it’s incredible. I walked into a restaurant the other day that normally, it’s just literally me and my wife on a Tuesday night, and it had an hour wait. And you know, it’s interesting as even part of that, is supply chain disruption. Part of the restaurant was blocked off because they didn’t have enough workers to cover that part. So you have this huge demand. Everybody’s locked up. They want to go out to eat. You only live once mentality, I’m going to go out to eat more often, combined with a bunch of people not being drawn back into the workforce for a variety of reasons. And so it’s a classic example. Will everybody be eating out five days a week two years from now? Probably not. Will the workers, come back when certain things change? Probably so.

Jonathan: All right, Peter. So, time to wrap things up. Your tip of the month?

Peter: So, my tip of the month is to look at your retirement accounts. A lot of people have various retirement accounts at old employers. And a lot of times, if we’re bringing on a client, we see 401(k) from a previous employer, 401(k) from two employers ago and really go through these and go, “How can I consolidate these?” Sometimes there are advantages to keep separate ones, but you know, talk with your advisor and confirm that you don’t lose any benefit by combining them and simplify that component of your financial life. And it allows you to be a better investor. It’s easier to coordinate investments.

If all of the investments are in one account instead of three, four, or five accounts, and then to take that account and coordinate it with your taxable account. And then, oftentimes, you can look and see, well, which 401(k) plan has the lowest fees. There’s a lot of considerations that go into this. Should I leave my old 401(k)s and go to an IRA? But just don’t orphan your old 401(k)s because you left your old employer. Take a half hour and talk with somebody and make a good decision about getting better control of your investments, simplifying your investment life, and also cutting your costs.

Jonathan: That’s a great one and my tip of the month, Peter, is very similar, which is again, it’s about simplifying your financial life. And this is really something I’ve been focusing on doing. I currently have four different credit cards. I have three checking accounts. One of them is a business account so that doesn’t really count, but I have another two checking accounts. It’s like, “Why do I need two checking accounts? Why do I need four credit cards?” In terms of credit cards, it’s probably worth having two in case one of them gets stolen. If you’re traveling abroad, you don’t want to end up in difficulty, but in terms of checking accounts, I can’t see much point in having more than one, unless you’re trying to maximize that FDIC insurance.

And I’m doing that not just to make things easier for me, I’m also thinking ahead to my heirs. I mean, I don’t want them to have to close all these accounts. The simpler your finances are, not only the easier it’ll be to keep track of everything, but also it will be easier for your kids after you pass away. So I’ve got to say: simplify your finances.

So that’s it for this month. You’ve been listening to me, Jonathan Clements. With me has been Peter Mallouk, President of Creative Planning, and we are Down the Middle.

Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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President & CEO, Creative Planning

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