Inflation Explains Everything

If you are under 40, you have heard stories about the impact of high inflation in the 1970s and early 1980s. For the last 40 years these seemed like far-fetched tales never coming to harm you. A new generation will now have their own story to tell with inflation at its highest levels in 40 years. The main causes? Energy costs, rent/home prices, and new/used vehicle prices all at historic highs. Two years of supply chain issues and workers changing jobs for higher wages have culminated in rapid inflation not seen in decades.

In May, the Federal Reserve increased the Fed Funds rate by 0.50% and are likely to do so again in June and July when they meet. This was the first increase of greater than 0.25% at a Fed meeting in over 20 years. The cause? Inflation. Last fall, the Federal Reserve was signaling that inflation was still transitory and The Market believed them, predicting the need for only one rate hike in 2022. After a meeting in January 2022, The Fed Chair, Jerome Powell, indicated that inflation was persisting at elevated levels for longer than anticipated and that the Fed will be aggressive in combating inflation. Market participants were skeptical and only “priced in” four or five rate hikes in 2022. Now, market participants are expecting the Fed Funds rate to be at least 2.50% at the end of 2022, up from 0.25% just six months ago.

Newly built home sales in April fell 16.6%, the biggest drop in nine years. The cause? Inflation. 30-year mortgage rates averaged 3.10% at the end of 2021 and have risen to 5.25% recently. Mortgage rates have risen rapidly in the wake of the Fed’s recent and expected increase in Fed Funds rate. Of course, inflation is not the only cause for the drop in sales. Historically low inventory levels have led to home prices reaching record levels. The drop in sales appears to be partially from higher rates and lack of available homes; however, prices keep going up.

Consumer sentiment is near its lowest levels in the last 70 years. The cause? Inflation. Consumers are experiencing the fastest price increases for goods and services in 40 years. While some prices have cooled off (lumber and used car prices), others remain elevated (oil/gas and groceries). Rent pricing was essentially frozen for 12-18 months as a result of COVID. However, rent has increased at their fastest pace in years. Consumer spending has not slowed down yet as they have begun dipping into savings.

Bonds are in the midst of their worst year of the last 100 years. The cause? Inflation. With the Fed raising short-term interest rates to fight inflation, it has caused mayhem within the bond market. The Bloomberg Aggregate Bond Index (tracks US investment grade debt) is down 10% year-to-date. This is the worst performance since its inception in 1976. The prior worst year was 1994 at -2.9%. Even Treasury Inflation Protection Securities are down more than 5% year-to-date (these protect against unexpected inflation changes).

Stock returns (as measured by the S&P 500) have been worse, falling nearly 20% year-to-date. The cause? Inflation, maybe. Inflation, Russia/Ukraine, interest rates, P/E multiple compression, recession worries, etc. Unprofitable companies have been punished the most over the past 6-12 months. Those with durable earnings or dividends have avoided the bulk of the carnage and the energy sector has seen a resurgence. The good news? Stocks remain a great long-term hedge against inflation. The average stock market return in the highest 15 years of inflation (6% or more per year) is 9%, essentially the long-term average. Companies can improve efficiencies, pass along price increases, and innovate. This is an edge that allows them to grow earnings and thus, see their share price increase.

The solution? Time and patience. Whether inflation turns out to be “transitory” and slow down over the next couple of years or last well into the decade is yet to be determined. What we do know is that US households and businesses are resilient, innovative, and persevering. The younger generations have experienced their own set of challenges that have taught them how to handle lean times. Plus, the wisdom from those who lived through it will be beneficial. As Warren Buffett says, “Never bet against America.”

Andrew Messerschmidt, CFA, is an Investment Officer at Cedar Rapids Bank & Trust. His direct line is (319) 743-7136.