The topic of rising inflation has dominated much of the headlines over the second quarter as year-over-year prices have risen the fastest we have seen since the 2008 recovery.
Inflation is the rate at which a currency’s purchasing power declines as it takes more dollars to buy the same goods. Inflation is not necessarily bad, as it is often indicative of a healthy growing economy. For example, the Federal Reserve (FED) has historically targeted an annual inflation rate of approximately 2%. However, when inflation spikes above this measure for longer periods, it can have a detrimental effect on the economy and the financial markets.
The most broadly followed measure of general inflation is referred to the Consumer Price Index (CPI). As of June 2021, the CPI increased 5.3% over the year.
At first glance, this recent increase is alarming, but at the same time we should look at it from a broader context. Looking back to June 2020, the CPI only increased 0.65% for the year. Therefore, over the two-year period, the average yearly increase in CPI equates to 2.99%, which is above the historical target of the FED, but not as too far different from the 5-year average of 2.43% (as of June 30, 2021).
There is an ongoing debate as to whether these recent inflationary pressures are “transitory” (short-term), as the economy works through robust consumer demand and lingering supply bottlenecks, or if this is a long-term shift. This uncertainty is currently priced into the markets as investors are aware of these issues. Unfortunately, there is no way to determine what side of the debate will be correct.
Therefore, to change our investment approach in light of this uncertainty would be akin to “market-timing” which is not a reliable investment strategy. The following quote from Dimensional Fund Advisors’ recent article “‘Everything Screams Inflation.’ How to Interpret the Headlines” further elaborates on this:
“It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back.”
Therefore, at this time we continue to believe the best course of action for investors is to “stay the course” with a diversified investment portfolio aligned with your risk profile.