Double Impact
The Potential of Inflation & Rising Interest Rates
By: Steven Higgins, Financial Advisor, Principal
Decades of lower than average inflation seem to have finally yielded to a somewhat new era of higher inflation. This next stage is likely the result of compounding stimulus efforts from the “Great Recession” (2008-2011) and then dwarfed by the COVID-19 pandemic response, which we entirely remain in the midst of. In the last eleven years we have seen the supply of money grow in the U.S. from $10 trillion in 2010 to now over $21 trillion. $6 trillion has come in the last year alone. With streets awash in cash, it seems rather natural that there would be at least some sort of inflation response. For a refresher, you can read all about it in our May 2021 blog post, “Inflated Expectations Part 2” which serves as both a primer on the subject and an update to our 2017 argument “Inflated Expectations” – the foundation for our belief that inflation will continue to play a larger role for investors and retirees as we move forward. This post will outline the concerns as we see them for our clients relating to the double impact of inflation and rising interest rates.
Long-Term Perspective
Financial news and media tend to focus on very short term horizon outcomes such as weeks, months, and at the most, the next quarter. Financial planning and investing involves more understanding and deference to macroeconomic cycles while giving less credence to short term predictions and events. For example, as planners, we’re more interested in your flight getting from point “A” to point “B” than what the exact moment will be when the flight gets a little bumpy or when the baby might cry. So, while the media speaks of inflation in the here and now, we are focused on mitigating the compounding effects of two macroeconomic workhorses – inflation and interest rates – and the challenges and risks they pose over time.
Inflation Impact
Simply Put: Inflation reduces the purchasing power of cash and cash-like instruments.
Predictable assets such as cash, bonds, and CDs play a role in the investment asset allocation of an investor. At Higgins & Schmidt Wealth Strategies, our investment models are made up of anywhere from 10% to 50% of these types of investments, depending on the goals and expectations of a specific client. The role of this asset class is to smooth out volatility and provide a stable source of liquidity in order to strive to protect our client’s ability to maintain their lifestyle in the event of prolonged economic, and often accompanying, stock market volatility.
Inflation has the effect of de-valuing the predictable types of investments by decreasing the purchasing power of a single dollar. As more dollars are created it takes more dollars to buy the same thing as before. Example: It now takes $450,000 to buy the same house that was $300,000 ten years. The house didn’t get better or bigger, the dollar just doesn’t go as far.
There is absolutely still a role for predictable pieces in the investment asset allocation. However, part of our role is to examine our client’s long term financial plans as they relate to their investment portfolio and recommending changes where necessary to avoid unnecessary inflation risk. Predictable investments have come to be known as “safe” and there could be a notion that an investor might seek them as a sort of haven. Like anything else when held in excess, the predictable assets could prove to be detrimental to an investor’s ability to meet their goals.
Interest Rate Impact
Simply Put: Interest rates and bond prices are on opposing sides of a teeter totter. As rates rise, bond prices fall.
The most key tenant of the Federal Reserve (the “Fed’) is to monitor and moderate inflation. The most basic way this is done is by adjusting the Fed Funds Rate, the rate at which banks borrow money from the Fed. As economic growth and inflation grow too “hot,” the Fed can increase the Fed Funds Rates to restrict liquidity in the market. Conversely, if the economy gets too “cold,” such as in a recession, the Fed can reduce the Fed Funds Rate in order to increase money supply to stimulate the economy. The Fed Funds Rate is a very short overnight rate and it’s the only rate that the Fed has a dial to control. While adjusting the Fed Funds Rate can ultimately have an effect on rates all across the yield curve, there can be much more dramatic and decisive interest rate moves and bond prices can change due to the market itself.
As investors sense, fear, or attempt to predict meaningful changes in policy they can very quickly sell bonds, bond funds, and bond ETFs and devalue a portfolio. If investors as a whole believe that inflation and corresponding rising interest rates are going to remain even incrementally higher over the foreseeable future, we would expect the values of bonds to drop over time. Again, our view on bonds and cash-like instruments is that they serve a specific purpose: to provide for liquidity and holding these investments in excess could prove to be a major headwind.
What We Are Doing Now
You should establish or clarify your long term financial plan and income planning needs. At Higgins & Schmidt Wealth Strategies, We have developed a process for this called MyStrategy Independence. We seek to have a clear understanding of our client’s income needs in addition to other sources of income. We want to know and communicate to our clients just how much predictability we need in their plan. Additionally, we are revisiting our clients Personal Investment Policy which is part of our process to develop mutual understandings of investment outcomes, expectations, and experiences. We want our clients to know what they should expect during different market cycles including periods of inflation, rising rates, and potential volatility. Finally, we are confirming that the expectations agreed upon in the Personal Investment Policy are in agreement with and reasonably have the ability to achieve the goals established in the MyStrategy Independence Plan.
Like all market cycles and events, we are approaching this period with optimistic caution. We anticipate periods of volatility in the future just as we have before and we have processes to manage volatility just as we have in the past. We simply believe that now, while the waters are calm, it’s time to mend the ship and make necessary adjustments. If you have questions about your specific situation or you know of somebody who would benefit from our guidance, please do not hesitate to reach out.
*Financial Sources: www.ycharts.com
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