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Up, Up and Away

Published on June 1, 2021

Peter Mallouk
President & CEO
Jonathan Clements Headshot

Jonathan Clements
Director of Financial Education

Investors’ latest fear: rampant inflation. Should we be worried–and what does it mean for our finances? Creative Planning’s Peter Mallouk and Jonathan Clements look at the evidence of higher inflation and consider the implications.

Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this podcast 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: This is Jonathan Clements, Director of Financial Education for Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, President of the firm, and we are Down the Middle. Today’s topic, Peter, inflation. If you go back to March of last year, when we were near the bottom of the stock market decline, investors were predicting inflation over the next five years of 0.1% a year. That was based on the difference between the yields on inflation index, treasury bonds, and today, barely 14 months later, investors are expecting inflation over the next five years of 2.6% a year. So what’s happened? What’s gone on in recent months? Well, investors have been fretting about inflation for years, but some of those worries have become much more widespread. People are worried about the level of federal government spending. They’re worried about loose Federal Reserve monetary policy. They’re worried about rising commodity prices. They’re worried about the pent-up demand from consumers as a result of the pandemic. And those fears focused in mid-May to a great degree when the Bureau of Labor Statistics announced inflation for the prior 12 months. That number was 4.2%, 4.2% for the past 12 months. That was the largest increase in a dozen years. So should we be worried? Well, the Federal Reserve doesn’t seem to be, at least at this point. I mean, they’re predicting that this year in core inflation, which excludes food and energy, we’ll run at just 2.2%. They’re saying 2% next year for inflation and 2.1% for 2023. And yet, it seems investors are worried. So, Peter, what is the worry? Is the worry just higher inflation? Is it hyperinflation? What are people saying to you?

Peter Mallouk: Well, let’s start with some definitions because I’m getting a lot of questions around what all these words mean because we’re hearing about transitory inflation, deflation, hyperinflation, stagflation. And really, what the government’s been worried about since 2008 is deflation. So you were talking about five, 10 years ago, this really all started in ’08 and ’09. Prices were going down. People would not buy a house for $400,000 because they thought a month later, it might be 390, and they wouldn’t buy it at 390 because they thought a little later it might be 380. It’s almost impossible to remember this in today’s world, but that’s how it was not that long ago. And we really had these great fears of becoming Japan. Deflation is a very, very scary thing because this psychology takes over. It’s hard to turn that around.

Jonathan: For investors, deflation is a much bigger problem than inflation.

Peter: Yeah, definitely. So deflation is a disaster, so the government is really interested in not having deflation. A lot of people talk about the Federal Reserve and having this conspiracy theory to create inflation. And that’s actually their mandate is to have a low unemployment and to create modest inflation. So they get up every day in the morning and say, “How do we create some inflation?” Because deflation is so bad. Now, inflation, we all know, and everyone gets that. That’s just prices going up. But we get concerned when they go up very fast, and we start to have images in our head of Venezuela and Greece and Lebanon and Nigeria, where it takes a barrel full of dollar bills to buy a piece of chicken. Because if there’s so much inflation, then the money itself becomes worthless. And this can also take on a psychological component. I think we’re seeing that right now. So we have a lot of different types of inflation happening now. One, we have real inflation. Things cost more today than they did a year ago. But they seem to cost more than we would normally expect, and I think that’s because of certain pressures that are on the system right now that are unique and finite and that are going to go away. So that’s what we call transitory inflation. So inflation that, yes, it’s here. It’s real, but it’s because of problems that are going to be solved. I’ll give you just a couple of recent examples. The Russians hack Colonial Pipeline, and there’s a sudden surge in the price of oil, transitory inflation. A shipping truck blocks the Suez Canal. Well, we know it’s going to eventually get unstuck. But in the meantime, we have some transitory inflation. What’s different here is we have countrywide transitory inflation. Why? Everyone’s been inside. It may as well have been a snow storm. We’re all inside, we can’t spend our money. And the government gives us more money, whether you’re a corporation, you got to bailout. You’re a private business, you got to forgivable PPP loan. You’re anyone else, you got a stimulus check. So when you’re inside, you can’t spend money. The government gives you more money. You come outside, you spend money. You go on more vacations. You buy bikes. You buy boats. There’s part of this that is transitory that eventually will get solved. The other part that’s transitory is we have supply chain issues. So when everyone wasn’t doing anything, corporations didn’t keep making stuff and shipping it. They just stopped. Containers wound up in the wrong parts of the world. Factories shut down. It takes them a while to create this stuff and get it to the right place so that the supply can meet the demand. So we know part of this is transitory, the debate is how much? And by the time the transitory part is gone, are we all psychologically so messed up that we do have permanent higher inflation? I do think we’re in a real inflationary environment now, though.

Jonathan: And why do you believe that?

Peter: Well, I think that if you look at there are some things that have happened that are really sweeping. Huge stimulus plan across two presidents, just literally like we just put so many dollar bills in people’s hands. And there’s a lot of debate about, well, Trump’s plan put money in these people’s hands, and Biden put money in these people hands. The economy doesn’t care that much. At the end of the day, you could just take a plane and fly it over the United States and drop dollar bills. Now, there’s more dollar bills in people’s hands, of course, things are going to cost more. But if I’ve got a lemonade stand and there’s five little kids with a quarter, I’m probably going to sell my lemonade for a quarter. But if all of them have 50 cents, I can probably raise my prices, and that’s probably not transitory. It’s probably not going away in a month or two. This is a real thing. The second thing is people have really decided, hey, you only live once, I’m going to have at it. Maybe I don’t need to save all this money. Maybe this is going to happen again. I’m going to be locked up for a year. I think there’s that lingering effect of, hey, I’m going on that vacation. I’m buying that car. I’m buying that bike. I’m buying that boat. I’m spending this money. I think this is more of a decade long thing, and I think that’s the part of inflation that is permanent. But overhanging all of this is the fact that we generally live now in a deflationary world. And so, there’s these very, very big market forces that want to keep prices down. So even though we have this huge new demand that I think is permanent, we’re getting so good at delivering goods at a lower cost that I think that deflationary pressure is going to contain it. So I’ll give you a couple of examples. One is the globalization of workers. If you’re Nike, and you were making shoes in the United States, and then you go make them in China. And that’s too expensive, so you might go to Vietnam. And when that gets too expensive, you’ll go to Africa. This wasn’t possible 50 years ago. So now what’s happening is we’re finding a way to have these lower cost ways of making these goods that keep the prices down. Second, technological advancement is keeping prices down. My new laptop cost less than my old laptop, even though it’s faster and better and a better picture. So it’s those are big, big, big deflationary pressures that keep at least parts of the economy in check.

Jonathan: I think there’s an important psychological element here. We all notice when we go to the grocery store, we go to the restaurant, when we go to the car dealership, and the prices are up, but we don’t really notice when prices come down. And you mentioned laptops. I mean, I remember 20 years ago, the rule of thumb was whatever laptop you wanted to buy, it was going to cost you 2,000 bucks. Today, you can go and buy a laptop for less than 1,000, and it’ll be vastly superior to the one that you could have bought 20 years ago, and it costs a fraction of the amount. And yet, we don’t really appreciate that. We don’t notice the deflation in our lives. We only notice when prices are going up. That said, I do worry that this narrative that we now have going that inflation is coming could turn into reality. That because everybody believes we’re going to see higher inflations ahead, not only does it prompt people to go out and spend their dollars before they depreciate, but it can also make workers demand higher wages. It could make people hold out for higher prices. And as a consequence, we end up with the inflation that we feared. And without that narrative, maybe it wouldn’t have happened. Oh, absolutely. I think we’re going to see a higher minimum wage. And I think that’s probably long overdue. But I think we’re going to see a higher minimum wage. We’re also going to see some of this be permanent. Because if I think a house is going to cost more next month or next year, I’m in a hurry to buy the house. Because if I wait, it’s just going to cost more. I think part of this gets tempered by demand being able to be met. I mean, we see shortages in all kinds of things, whether it’s lumber, steel, whatever. These will resolve themselves one way or another. There’s a saying, the cure for high prices is high prices. Eventually, if the price is high enough, there’s enough people that will want to come in and sell things at a lower price that we’ll keep it somewhat in check. So even while the price of many things are going up, the one thing where prices have clearly gone down is the price of borrowing money. What we’ve seen over the past 40 years is this huge drop in interest rates. And so, for many people, even while prices are going up, for instance, for houses, for cars, the price of buying these assets has actually come down because it costs less to take out a mortgage. It costs less to take out a car loan. And in fact, even with home prices going up in recent years at a fairly decent clip, the affordability of housing has actually improved because of those lower mortgage rates.

Peter: Right. I think it’s really interesting the psychology of this, though. So we know that $100 buys less groceries today than it bought 10 years ago, and we know it buys a lot less than it did 50 years ago. And I look at what’s happening with housing very similar to the national debt. So the national debt has gotten so big, taxes are not going to solve the problem anymore. Republicans and Democrats know that. The only way out is to create inflation. So let’s use a house as example. You’ve got somebody who’s got a half-million dollar house, and they owe 400,000 on it. Hey, no problem. You have a half-million dollar house, and you owe 700,000 on it, big problem. You feel poor. You can’t borrow money. The bank is scared of you and so on. So what’s one way out of this problem, other than paying down the debt, which might be impossible for someone with a $500,000 house and 700,000 mortgage? Well, we could inflate the value of the house. We could make the house be worth a million dollars. How might we do that? We could give everybody in the neighborhood a bunch of money, and so they can afford to buy the house, pay more. And the second thing we do is we can lower interest rates so that people can afford the same monthly payment to pay more for the house. This is literally what the federal government is doing now to be able to contain this national debt. They’re going, “Hey, look, we owe $30 trillion. One way out of this is to make the $30 trillion actually be less compared to the value of everything else. If there’s inflation and everybody’s house is worth more, and everybody gets a higher income, we can contain the debt. The mountain of debt will seem smaller relative to all of that.” And it’s why people call inflation the hidden tax. No one complains about it. If you inflate the value of my house and you inflate the value of my wages by 10%, but I can buy 20% less stuff, I still feel good because my balance sheet is higher, but my purchasing power has gone down because the dollars have diminished in value. We are seeing that with houses now, and we’re seeing it with the way the federal government’s handling the debt.

Jonathan: And you make a good point there, Peter, which is for people who are borrowers, and we’re not talking about just the federal government, for people who are borrowers, a little inflation is not a bad thing. If you are sitting there with a home with a fixed rate mortgage, and inflation drives up the price of your house and it drives up your salary, but your mortgage payments are staying the same, you’re a net winner. So Peter, the million dollar question, you’re listening to this podcast, you’re concerned about inflation in the years ahead, what do you do with your portfolio?

Peter: So if you look at the basic asset classes, stocks, bonds, real estate, cash, for example, the winners in an inflationary environment are stocks and real estate and the losers are bonds and cash. So let’s start with the obvious. If I’ve got a million dollars sitting in cash, and every year my million dollars buys less, well, this isn’t a great place to be. I’m earning zero on my cash. And next year, a house is going to cost more, a sandwich at Jimmy John’s is going to cost more. I’m losing purchasing power every year. Cash is a disaster. Bonds tend to suffer. Today, 80% of bonds pay 2% or less. That’s the lowest in history. So let’s say you have a million dollars in bonds, you’re collecting your 2%. If inflation is at four, on paper, it says you’re making money. But those dollars, even after your gains, will buy you less every year. So you’re losing your purchasing power. Hershey’s bar costs 5% more every year, and you’re earning two, you’re losing. Stocks and real estate are different. Stocks and real estate tend to do well in an inflationary environment. So if the cost of everything that goes into a house is higher, it makes sense that all houses will go up to some degree in value because we know that to go build my own house is going to cost more than to buy one of these houses. If everything that goes into, say, a Chipotle bowl at Chipotle costs more, every ingredient costs more, Chipotle is going to charge more for that bowl, and it will get reflected in their stock price. So stocks and real estate tend to go up when there’s inflation, bonds tend to do poorly, and so does cash. And those are some general guidelines. There’s all kinds of other asset classes from gold and cryptocurrency and so on. But from the big picture, those are the real stores of value, real estate and stocks.

Jonathan: And of course, people will say, “Okay, so if real estate and stocks are the place to be in an inflationary environment. Why don’t we just put all our chips on those?”

Peter: So here’s the thing is the market’s dynamic and whatever we’re talking about, something different is going to happen. So we could say, “Okay, I’m going to be all in stocks and real estate,” and we go do that because we’re talking about inflation, and everyone’s talking about inflation. We think there’s going to be inflation, and sure, 10 years from now, if you told me to bet, I’d bet everything costs a heck of a lot more, and we’d win to be in stocks and some real estate. But what could happen in the meantime is another pandemic, a cyber attack, a terrorist event, something we’re not thinking about. And what happens in those events? Another terrorist attack, for example, just because we’ve been through one and we know what happens. People do the same thing they did with COVID, they cocoon. They go inside. They stop spending money. We have deflation, what does best in that environment? Bonds. So we have to have a place to go because we live in an uncertain world that no matter what is happening… I know at Creative Planning, no matter what is happening in the world, we need to know our clients can get that monthly check. They have to, no matter what, if they’re retired. And so, we have to have enough and things like bonds that are going to be available to them when everything hits the fan. And everything hits the fan all the time. We’ve had the tech bubble, 9-11, ’08-’09, the pandemic. There’s going to be four or five more minimum in our lifetimes, if we live a normal life expectancy. We have to have a place to go when that happens.

Jonathan: All right, Peter, I’m going to have to cut you off there and ask you for your tip of the month.

Peter: So tip of the month for me is consolidate your debt. If you’ve got a bunch of different debts at different rates, this is a great time, we were talking about lower rates earlier, to find the lowest cost of capital. Whether it’s borrowing against your investment account or borrowing against your house or a credit card you can transition to with a zero rate for a while, take all those debts, move it to that. Rates are so low. There should be an opportunity to find a way to save some money there.

Jonathan: So going back to the theme of this podcast about people opening up their wallets, leaving their homes, getting vaccinated, and starting to enjoy life once again, my tip of the month is this, think about what you missed the most during the course of the pandemic and what actually turned out to be not so important. Whatever it is that you really missed, that’s probably a good sign for how you should spend your dollars in the year ahead. That should be an indicator of what will bring you greatest happiness. Meanwhile, if you find that certain things, hey, you didn’t really miss it, maybe you should not go back to spending dollars on those things. So find a silver lining in the pandemic and use it to guide your spending in the months ahead. This is Jonathan Clements, director of financial education for Creative Planning. With me has been Peter Mallouk, president of the firm, and we are Down the Middle.

Disclosures: 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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