Investors can be forgiven for nervously thinking back to the severe inflation of the 1970s. After all, they’ve grown used to inflation running no more than 2 percent annually over the last decade. And this summer’s surge in prices — year over year, inflation increased by more than 5 percent for four consecutive months — was startling. In fact, it was the biggest such spike since July 2008.
However, we think the jump in inflation is likely to be transitory, with both near-term and long-term inflation drivers moderating in the coming years. Nevertheless, consumers should be prepared for higher prices in the short term, and now may be the time for them to rethink the traditional 60-40 stock-to-bond ratio in their portfolios.
The sharp increase in the Consumer Price Index inflation rate has been heavily driven by a concurrent 25 percent jump in energy prices, which consumers have felt at the gas pump and in other transportation costs, including airfare. But even the core Personal Consumption Expenditures index — which is inflation with food and energy stripped out, and the figure that the Federal Reserve uses to set monetary policy — hasn’t been spared.
Take auto dealerships, for example — many were forced over the last year to contend with empty lots due to shortages of semiconductors and other parts. As the Covid-19 recovery gained steam, demand for transportation accelerated. New and used auto prices soared, and the auto rental market went even higher. Meanwhile, port and shipping congestion, truck driver shortages, and reduced air-freight capacity also contributed to higher transportation costs.
In the near term, Ned Davis Research is looking at three factors that could indicate that the summer spike was just an anomaly: inflation expectations, housing costs, and wage growth.
As far as inflation is concerned, actual inflation isn’t the biggest worry — it’s the expectation of continued or future inflation that sends the market into panic mode. Currently, inflation expectations in the U.S. are near their earlier peaks, but they’re still trending higher in Europe.
On the other hand, housing costs — which are a big factor in inflation metrics — have made a U-turn since the early months of the pandemic in 2020, when apartment rents collapsed and eviction moratoriums and mortgage forbearances helped keep a lid on prices. Now, offices are reopening, the moratoriums are ending, and rents are starting to firm, which may be the beginning of things to come in the rental market, because house prices (which have soared to record gains in 2021) typically lead rental prices by about 18 months.
The lack of wage growth over the last year is one sign that we’re not entering a period of sustained high inflation. Indications of permanently higher inflation should show up in wages and compensation, but despite a record number of job openings and anecdotal reports of higher wages, such evidence has thus far failed to appear to any great degree in the broader measures of compensation. In fact, nonfarm unit labor costs have effectively been unchanged over the past year.
Long-term inflation drivers look even more promising. The robust pace of technological innovation — which actually accelerated during the Covid lockdowns — has prevented inflationary pressures from getting out of hand, and although trade with China cooled in 2019 and 2020, it picked up with the rest of the world. Some production has shifted to the next lowest-cost producer, and the world is moving more toward regional supply chains, such as those in North America, Europe, and Asia, which reduces the risk of single-source suppliers and the associated supply-chain disruptions.
Although we expect inflation to moderate and stay close to or slightly higher than the targets set by the central banks, we also believe that investors should consider repositioning their portfolios away from the usual 60-40 mix of stocks and bonds. Given the low levels of yield for bonds and cash, it will be challenging if not impossible for investors to achieve their return objectives using the traditional allocation ratio. Equities, however, should continue to do well and deserve an overweight allocation of perhaps 65 percent or 70 percent, while bonds — which should include allocations to private credit — should have an underweight allocation of roughly 20 percent. Any allocation to cash, however, should be kept to a minimum.
Investors should also consider adding or increasing their allocations to commodities, which can act as a hedge against inflation, as well as to real assets such as infrastructure, residential real estate, and select areas of commercial real estate and REITs.
Joe Kalish is chief global macro strategist at Ned Davis Research. NDR is a global independent investment research, solutions and tools provider owned by Euromoney Institutional Investor.