How will inflation impact investors in 2021?

Updated November 10 | Market News

The resurgence of inflation as a concern for consumers, businesses and investors is one of the major economic stories of 2021. For most of the past four decades, changes in the cost-of-living were modest from year-to-year, often in the range of 2 to 3 percent annually. Beginning in May of this year and continuing through September, the 12-month inflation rate, as measured by the Consumer Price Index (CPI), topped the 5 percent mark. In October, it rose even higher, to 6.2 percent for the previous 12-month period. This represented the largest 12-month increase in CPI since November 1990. By contrast, as recently as February, the inflation rate for the previous 12-month period was just 1.7 percent.

If the CPI for all of 2021 comes in at a level of 5 percent or greater, it would represent the largest calendar-year jump in the inflation rate since 1990.1

The environment has generated several key questions about what the future holds, including:

  • Is inflation back as a long-term consideration or is this just a temporary blip?
  • What is the potential impact to you as a consumer?
  • What could higher inflation mean for your personal portfolio?

What sparked the recent inflation spike

In the early days of the COVID-19 pandemic during the spring of 2020, living costs were relatively flat. This came as many people lost their jobs and the economy went into a deep spiral (declining at a 31% annualized rate in the second quarter of 2020). The downturn proved to be short-lived, as the economy quickly rebounded, the job market sprang back to life, and consumers acted on some of their pent-up demand.

One of the bigger issues that turned inflation into a headline issue this year is the sudden imbalance between supply and demand among specific sectors of the economy. In recent months, this imbalance affected such items as lumber (reflecting significant new construction and remodeling), airfares, lodging, energy costs and used car prices. “Inflation is always about the difference between supply and demand,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management. “In this unusual economic environment, people are spending more on specific items, driving up demand.”

Exacerbating an inability to keep pace with demand are recent supply chain disruptions. For example, a shortage of semiconductor chips, now a key component in the production of motor vehicles, has led to a drop in inventory at automobile dealerships. Backups in unloading container ships and moving freight across the country have also played a role in supply chain issues.

The pandemic may be another factor contributing to today’s elevated inflation rate, according to Eric Freedman, chief investment officer at U.S. Bank Wealth Management. “Individual countries are managing the response to COVID-19 in different ways. Nations lack consistency in their COVID protocols, contributing to the persistence of inflation in 2021,” says Freedman. In other words, if a country forces business activity to slow or shut down as a precautionary measure, it may contribute to the supply chain disruption that has marked the recent inflationary surge.

How long will higher inflation persist?

One of the biggest questions is whether the current uptick in inflation is transitory in nature, as the Federal Reserve (the Fed) has projected, or if it will remain an issue for an extended period of time. “Many key indicators look to be transitory,” says Rob Haworth, senior investment strategy director at U.S. Bank. “But prices may be headed higher for housing [typically reflected in rental rates in the CPI] and energy costs.”

Haworth points out that the issue investors are closely watching now is whether shortages persist and prices for goods continue to rise, or if instead, supply constraints resolve themselves and inflation rates moderate. The Fed has indicated that it continues to believe issues will resolve themselves and that there won’t be a sustained period of higher inflation. To this point, the Fed has held the line on the key interest rate it directly controls, the target Fed Funds rate. The Fed’s zero interest rate policy remains in place, and Fed chairman Jerome Powell maintains that the policy should remain in place through 2022. Notably, some members of the policy-making Federal Open Market Committee disagree.

“The issue has less to do with how high the inflation rate is now rather than how long it stays elevated,” says Hainlin. “If this proves to be a transitory phase, the Fed can delay raising rates as they’ve been projecting, but if it proves more persistent, they may need to be more aggressive in combatting inflation and start raising rates sooner.”

Freedman agrees that it’s an open question. “While we’re still in the camp that says inflation is going to subside from current levels, it’s clear that the definition of ‘transitory’ is lengthened with respect to inflation.” Yet Freedman sees signs that the rate won’t continue to linger above the 5% level for much longer. “The market indicates that inflation will be in the 2.8% annualized range over the next three years and lower than that when you look farther out,” according to Freedman. “That’s a clear sign the market anticipates that the current inflation surge will subside.”

Freedman suggests we’ll see a noticeable drop in overall inflation by the middle of 2022, if not sooner, but notes that timing is difficult to predict. “By the second half of next year, things should be closer to normal,” he says. Yet some variables are worth monitoring.

Two key areas to watch – energy and wages

For the 12-month period ending September 30, 2021, energy costs had the biggest impact on the inflation rate, jumping nearly 25%.2 Freedman points out that this indicates the Organization of Petroleum Exporting Countries (OPEC) continues to have significant influence on the oil market. “OPEC is not producing up to levels some expected to see, and the U.S. has not brought enough capacity online to add to supply in a meaningful way.” With reduced supply an ongoing reality, Freedman believes there is still a risk that oil prices could continue to rise, even though in October 2021, the price of crude oil was already at its highest level since 2014.3

The job market is another area facing its own supply-demand disruptions. While millions remain out of work, the Bureau of Labor Statistics reports there are 10.4 million job openings.4 In addition, a number of people have stepped away from the work force. The question is whether that’s a temporary trend or if it could turn into a sustained issue. “We’re seeing COVID-19 remain a concern for people,” says Freedman. “Many are nervous about switching jobs or looking for other jobs in this environment.” He believes labor trends at the end of 2021 and the first months of 2022 will better define whether labor shortages will force more significant wage growth. If that occurs, it could contribute to an extended period of higher inflation.

Investment implications of today’s inflation environment

There have been few indications of concern in the market over the most recent inflation reports. Major stock indices have lingered near record highs for much of 2021. Bond yields (which move in the opposite direction of prices), after spiking up in the first part of the year, declined significantly and only recently have moved higher again. Yet the benchmark 10-year Treasury note remains below the 2% mark.

Investors, as always, pay close attention to actions by the Federal Reserve. The Fed has provided clear indications that a strategy of significantly tapering its monthly bond purchases will be initiated and continue through the first half of 2022. The tapering strategy may represent an opening maneuver by the Fed to help temper inflation rates. The Fed retains a policy of maintaining an inflation rate in the 2% range over the long term. Whether it will have to take additional steps (such as raising the Fed Funds rate) to cool down the economy as a way of slowing down inflation growth remains to be seen.

Hainlin also notes that investors will also be attuned to what corporate earnings reports signal about the impact of the recent inflation surge. “If higher costs take a toll on profits, that could be a more tangible sign of broader concerns about inflation’s impact,” says Hainlin.

Freedman says the biggest risk facing equity markets today is tied to Fed policy. “The market might react negatively even if the Fed simply signals that interest rates are headed higher than markets currently expect,” says Freedman. “If this happens at a time when corporate profit growth slows, it has the potential to create headwinds for equities.” While these are risks worth watching, Freedman believes that stocks continue to be well positioned relative to other asset classes and are poised to generate positive returns in the near term.

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