Inflation is a phenomenon that impacts everyone. Granted inflation has been quite tame for the past 40 years, it hasn’t always been so. Inflation ramped up quite a bit in the 1970s as a result of various factors, the most famous being the oil embargo and rising oil prices. Beating the inflation of the 1970s and early 1980s required extreme measures taken by the then Fed Chair, the late Paul Volcker. Mr. Volcker had to raise rates into the double digits, which largely paved the way for the declining interest rate environment we’ve experienced in subsequent decades. Our standard of living as we know it today has benefited greatly from a low inflationary and declining interest rate environment. Additionally, our investment and retirement accounts have benefited handsomely as well. Low interest rates and low inflation lead to higher financial asset values. In a previous post we discussed price versus valuation. Valuation is often viewed in terms of a multiple or ratio of price relative to a company specific metric such as earnings or cash flow. Low inflationary environments (not too low though) tend to lead to higher multiples/ratios and typically higher prices, all else equal.

Inflation has been a popular topic in the financial world as many believed inflation would run wild this past decade given the amount of money that was created. It didn’t happen the way many very smart people thought it would and we’re still in a low inflationary environment, at least from a headline inflation perspective.

This isn’t to say that there isn’t quite a bit of inflation in certain pockets. The November inflation rate for the Consumer Price Index was right around 2%. That included some negative and low inflation figures for vehicles and some other items. It also included some larger inflationary figures for medical care and medical insurance.

 

While the overall headline figure is moderate, not surprisingly the health care figures are pretty astounding, especially the health insurance premium inflation. Again, most of us are already aware of this inflation because we’re experiencing it first hand. Most of us probably aren’t aware that new and used vehicles, for example, are experiencing negative inflation. That’s because we don’t buy a new/used vehicle every month or every year like we do medical care services and health insurance.

My point in writing this post isn’t to get into the nuances of inflation or to debate why we haven’t seen more or less of it. I’m thinking more along the lines of an inflation surprise. We’ve seen massive inflation in financial asset prices (i.e.,stocks) over the past 11 years. We haven’t seen nearly as much inflation in other types of assets such as real estate, commodities and other types of real assets. Inflation in real types of assets is what can be quite a bit more painful for us as consumers and for our investment portfolios. We’ve had a great run over the past 11 years but is it possible that the inflationary forces that drove up financial asset values reverse or cause real asset prices to rise? I don’t think the average investment portfolio is prepared for such an outcome.

With all the money that has been created in the past 11 years, an increasingly protectionist mentality throughout parts of the world, extremely high debt levels and ever increasing geopolitical tensions, it feels like higher inflation is certainly a more distinct possibility than it might have been a few years ago. Don’t get me wrong, I’m not predicting higher inflation. I’m simply looking at the current state of the world and financial markets and doing a little scenario analysis.

I wonder if we’ve become too complacent with the moderate inflation environment we’ve been in for a number of years. If real asset inflation does pick up how does that play out across prices within the different asset classes? Will governments eventually opt for higher inflation to help alleviate the debt burdens they’ve run up in recent years? There are a lot of questions to consider under such a scenario.

We obviously can’t predict what’s going to happen with inflation, but we need to construct and manage portfolios that can properly handle an increase in inflation. A well constructed portfolio should account for such an outcome.