Have you noticed? The cost of a trip to the grocery store or hardware store has risen in recent months. This has the news media doing plenty of fear mongering about inflation.
To be fair, prices of commodities like corn, soybeans, lumber, and iron ore have all more than doubled over the last year. This is an undisputed fact, and certainly concerning. However, the effects on consumer prices have still been relatively limited — The consumer price index (a measure of the cost of goods and services to the consumer and a best guess about the rate of inflation) rose by 2.6% annually at it’s last reading.
That’s certainly a higher level of inflation than we’ve seen in recent years!
Other goods, like computer chips and graphics cards are undergoing severe shortages right now. *If* you can get your hands on a new graphics card, you’ll likely be paying 2-4 times retail prices. It’s completely outrageous what scalpers are selling graphics chips on eBay for.
All of these things combined have some people very worried about inflation. The shortages and rising prices are hard NOT to notice. But do we really need to worry about the inflation boogey-man? Is hyper-inflation a real fear? And what exactly can the average person do about it to safeguard their wealth?
Don’t Freak Out
Ok, lets start at the beginning. The first thing to know is that inflation isn’t necessarily a bad thing. A little inflation is actually a good thing, and the FED currently sets an inflation target of 2%. Low levels of inflation are actually nothing to worry about, and are part of a healthy economy.
It’s the state of extremely high inflation called hyper inflation that’s actually something to worry about. Generally speaking, a currency is considered to be in state of hyper inflation when the cumulative inflation rate over three years approaches, or exceeds, 100%.
Rapidly rising prices and a loss of confidence in the currency causes consumers to quickly dump the local currency in exchange for other currencies, physical goods, or other hard assets. In a short amount of time, a currency in a state of hyper inflation becomes rapidly devalued, and essentially worthless.
Under a state of hyper inflation, a currency can become completely worthless in just a matter of months. There are countless examples in the real world of this happening around the globe.
It’s usually very bad-news when hyper inflation hits. Thankfully, we’re not there yet. Hyper inflation does not appear to be happening, despite the amazing levels of economic stimulus we’ve seen over the last year.
If you look at the exchange rate of the US dollar against a basket of major currencies, there’s no indication that the US dollar is becoming worthless. The dollar is still the world’s reserve currency (the currency most often used for global trade), and I see no indication this is going to change anytime soon.
In my opinion, it’s way too soon to start worrying about hyper-inflation… but we could be in for a period of higher inflation.
Why Are Prices Rising?
Yes, prices do seem to be rising. Believe it or not, rising prices is actually a global issue, NOT a problem tied to the US dollar. It’s happening all around the world to varying degrees (in many currencies), mostly due to supply chain and logistics issues connected to the COVID-19 pandemic.
Not only did the pandemic slow factories last year, but it caused extremely rapid changes in consumer behavior. Instead of spending cash on things like travel, eating at restaurants, or going to football games, people have had to find all new outlets to spend money.
These days we’re working-at-home, lifting weights in our home gyms, cycling around the neighborhood more, cooking meals at home, and even getting a few home renovation projects done.
These changes in consumer behavior have ultimately altered the demand for various commodities ‘up’ the supply chain — like steel, chemicals, plastics, food, and even wood. The prices for which, have skyrocketed in recent months.
Factories are cranking-out goods as quickly as they can, but limited supply and long lead times of certain commodities have definitely slowed production of certain items.
This is the main reason prices are rising — COVID-19 rapidly changed our behavior, and supply chains and factories are still adapting to meet those changes in demand.
Example – Lumber Prices
If you’ve visited a hardware store in recent months, you’ve probably noticed lumber prices are higher. Lumber prices are up over 200% since this time last year. This increase varies depending upon the type of lumber product, but for the most part lumber prices are WAY UP compared to early 2020.
Partly the price increase is happening because of increased demand for new homes (urban dwellers moving to the suburbs), as well as increasing levels of home renovation, and DIY home improvement projects.
Don’t worry, the world didn’t suddenly run out of trees. Lumber prices might be soaring, but logs are still dirt cheap. The problem? Margins at sawmills are skyrocketing. Quite literally, sawmills are cranking out the lumber as fast as they can, but demand is far exceeding supply. In economic terms, this excess demand leads to rising prices. Supply should eventually expand to capture those excess profits.
This means new sawmills will be built, or capacity increased at existing sawmills to meet the growing demand for lumber. This kind of economic expansion takes a long time to occur however, so we may be in store for higher lumber prices for several years until supply comes back into balance with demand.
I wouldn’t be surprised if it takes 1-2 years before lumber prices begin to “normalize” again. In the meantime, high lumber prices are going to increase the cost of new homes, as well as any home renovations you might have been planning. Be warned!
The Good News
The good news is that if you have the bulk of your investments are in stocks, historical data says you’ll do OK (generally speaking) if inflation is on the rise.
The price of stocks generally rises to keep up with inflation, but it’s not necessarily smooth ride. Actual compounded returns slow significantly during periods of high inflation, and “lost decades” can occur (where stock prices don’t actually rise for an entire decade). It’s not good news.
Buffet once described the effect of inflation on stocks like a tapeworm:
“For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.
… The tapeworm of inflation simply cleans the plate.”
In other words, don’t expect to make big returns on stocks during periods of high-inflation. Investors should generally avoid holding fixed income investments (like bonds) as well as investments that require large fixed assets to continue doing business.
Instead, seek out those investments with pricing power — The ability to raise prices without losing customers. This will be key to staying ahead as prices rise. Other good investments to hold during periods of high inflation would be: TIPS, real estate, and investments tied to commodity prices.
A Little Sensible Advice
Yes, all the data seems to indicate we’re going to see a period of higher inflation. It may be several months before these price increases start to show up at your local store, but they are coming.
Don’t freak out! Modest levels of inflation are nothing to worry about. Just be sensible, and follow some basic money rules for periods of higher inflation:
- Don’t hold large amounts of cash or bonds, if you can. Inflation will eventually eat away at that cash, lowering your overall purchasing power.
- Good stocks with low fixed costs and high returns on equity can still earn real returns during inflationary periods.
- Stick to investments that will rise with inflation — Stocks, TIPS, real estate, and investments tied to commodity prices.
- Maintain a healthy amount of leverage. Remember, as prices rise due to inflation, paying back debt becomes continuously easier over time. Don’t rush to pay off your mortgage if higher levels of inflation are coming!
- If you can, try to use alternatives for those commodities seeing the largest price increases. You could save yourself a lot by not being so picky.
Furthermore, this wave of increasing inflation we’re experiencing is expected to be temporary. Don’t imagine it to be a giant monster that’s going to eat all your hard-earned savings. It’s possible this inflationary period might only last a few months.
Then again, nobody can accurately predict the future. It pays to be prepared for anything… but remember to stay sensible. Other than a few ‘outliers’ like the price of lumber, inflation is still fairly tame.
Don’t turn it into a monster before we truly understand what’s lurking in the shadows!