Inflation and YOUR Portfolio

Inflation—which is defined as a general price increase of goods and services in an economy over a given period of time—has been a much-discussed topic in the last 18 months or so. We all know how it affects our purchasing power at the grocery store, but how does it impact our investment portfolio? Jake Falcon, CRPC? and I discussed how investors can be proactive to guard against inflation, as well as strategies we’re pursuing at?Falcon Wealth Advisors. A summary of our conversation is below.

Jake:?There are three key factors that contribute to inflation, Cory. What’s the first?

Cory:?The first one is demand. When there is more demand than supply, businesses raise prices and consumers are often willing to pay more. We’ve experienced this a lot in the last few years.

Jake:?A classic example of this is used cars. There were supply chain issues during the pandemic that led to fewer new cars arriving on dealership lots, which drove up the value of used cars. There was demand—people needed cars—but the supply wasn’t there.

The second inflation factor is the cost of producing goods and services. This can come in the form of employers paying higher wages to employees, rising raw material costs, taxes and more. All of these can cause businesses to raise the prices of their goods and services.

For example, my wife and I own a magazine company and the cost of paper has risen significantly, making it far more difficult to turn a profit. This of course impacts many business decisions we make around the magazine.

Cory:?That’s an excellent real-world example. The third factor we’ll discuss is monetary policy. When the Federal Reserve in the US increases the money supply—often referred to as printing more money—consumers have more purchasing power, which can drive up prices.

Jake:?Yes, we’ve seen this in recent years with the economic stimulus packages during the pandemic. More money in the system generally drives up prices.

Cory:?Of the three factors we just discussed, is there one you think drives inflation the most?

Jake:?I actually think human behavior is the biggest driver of inflation. If people are willing and able to pay higher prices, it’s a snowball effect. But if people stop paying those higher prices, that can calm inflation. Remember how you couldn’t find toilet paper at the start of the pandemic? That was due to human behavior, not any of these three factors.

Cory:?And I think monetary policy can directly connect to that human behavior. Someone may be far more likely to pay for something if they’re receiving money that didn’t directly come from their labor

Jake:?That’s true to an extent, but I know of people who put their stimulus checks in savings. That’s why I believe human behavior is the biggest driver of inflation. Psychology—and the emotions of fear and greed, specifically—drive so much of our behavior. If we’re scared that we may not be able to buy toilet paper, we’re going to buy as much as we can when we have the opportunity.

An inflationary environment does offer some benefits, believe it or not. It?encourages people to invest?rather than leaving money in the bank. Investors often realize they need to put their money to work to keep up with inflation. And it encourages people to buy other assets, like homes. People worry that if they don’t invest in an asset now, it will only cost them more later.

What’s another benefit of inflation?

Cory:?It reduces the “real” value of debt—rising prices means the value of any debt you have is essentially worth less.

Jake:?And that’s why some use the term “real” to adjust returns for inflation.

Of course, there are many negatives associated with inflation. You can’t buy as much with the dollars you have. If toilet paper was $7 and is now $10, you can’t consume or invest as much of the money you bring home. What’s another negative of inflation?

Cory:?It can bring about feelings of uncertainty and make it more difficult for many people to make decisions. For example, someone may be aware they’re not financially ready to buy a home, but inflation can make them feel the need to buy today rather than waiting until they are, because they fear prices going up.

Jake:?Yes, we talk about this with clients all the time regarding real estate. While homes can be investments, we encourage our clients to think of them as a place to live and make memories. With that said, a lot of realtors and mortgage brokers are encouraging people to get in the game, as prices may continue to go up.

One more negative: inflation has an outsize effect on people living on fixed incomes. If you receive a fixed monthly pension, but inflation rises 7% in a year, that pension doesn’t go as far as it used to. Thankfully, Social Security has cost of living adjustments for its recipients.

So how does our team at?Falcon Wealth Advisors?aim to help our clients ride the wave of inflation? One way is by investing them in companies we believe will benefit from inflation, or companies that aren’t as prone to risk in inflationary environments. We don’t sacrifice portfolio diversification to pursue this strategy, but we can still keep inflation front and center when trading individual stocks for our clients.

Cory:?Yes,?inflation is not inherently bad?for the market or companies. Some companies do better than others at adapting to this environment. The market in recent years has rewarded companies whose management teams have accounted for inflation and punished those who have not.

Jake:?Indeed. Our team at?Falcon Wealth Advisors?is passionate and skilled at researching what companies could do well in a particular environment and what companies may not.

And of course, you don’t want to ignore?bonds?during times of inflation. We believe inflation, coupled with the Federal Reserve continuing to raise interest rates, has presented a tremendous opportunity to add bonds to client portfolios. As bonds mature, we’re able to buy new bonds that are paying much higher interest than a few years ago. If the Federal Reserve steadies or lowers interest rates, our clients will have bonds locked in that offer appealing yields. This scenario could be a big win for investors.

Cory:?While we’ve seen inflation—per the?Consumer Price Index—come down from about 9% in summer 2022 to about 3% this year, we’re still seeing the inverted yield curve in the bond market. This happens when short term bonds pay higher interest rates than intermediate or longer term bonds. While it may be tempting to want to buy only short term bonds, the market isn’t pricing in inflation as a multi-year event, so we want to help clients lock in appealing returns on bonds for the intermediate and long term as well. A diversified bond portfolio is important, just like a?diversified stock portfolio.

Jake:?Yes, the central bank has made a ton of progress, considering we were at 9% inflation a year ago and are now around 3%. I think they waited too long to raise interest rates, which helped produce this environment, but they have been vigilant about lowering inflation and it appears their efforts are working.

Every market environment presents opportunities for investors and our team at?Falcon Wealth Advisors?helps clients seize these opportunities. If you would like to learn more about how our?financial planning?and?investment management?practice sets up clients for long-term success, please contact us today. You can reach us directly [email protected].

Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.