• Inflation is up, the Fed has to react to slow price increases
  • Value companies do better, many growth companies suffer

What does inflation mean? And what does it mean for you?

Whether your grocery receipts are surging  or whether you’re seeing the “i” word in all of your New York Times morning newsletters, inflation is taking a whole new role in your day-to-day life. As humans who run on emotions, it is easy to succumb to worry: how is this going to affect my future? Will this change my retirement savings plan? Should I stop investing?

The answer is simple: take a look at the big picture. 

Inflation is not a novel concept and occurs when the general level of prices increase due to either strong economic growth, loose monetary policies, easy fiscal policies, or supply side shocks to the economic system. With the pandemic, we have had all of these usual culprits come to fruition at the same time. The economy recovered strongly from the 2020 shutdown, the government handed out checks to workers forced to stay home, and the Federal reserve set interest rates to zero in order to provide enough liquidity to the system to combat the potential disastrous effect of the COVID-19 pandemic. Now that inflation is here, the Fed has to raise interest rates to restrict the money supply in order to combat inflation.

An example of higher input cost: Lumber

Lumber, which represents 15-18% of home buildings costs, experienced a price increase from $400 to $1700 between 2020 and mid 2021. Following a short term fall in July/September, when hope for “back to normal” changed and homebuying was not as rapid as it was during the pandemic, the price dropped. It has since slowly climbed back up to $1300. This trend is visible in copper, corn, and oats as well. The rise of these commodity prices affect consumers in two ways: many companies cannot handle the increase in price of their input costs, so they transfer the cost onto consumers with higher prices. Because of these higher prices,  consumers will purchase fewer products made with these commodities. As a result, economic growth is stifled.

Commodities - Rise in prices

To curb these effects, the Fed will eventually start to raise interest rates once again. This will result in new bonds sold at higher interest rates and therefore existing bond prices will decrease. 

So does this mean you shouldn’t invest? 

No! When we look at how inflation affects the whole market, we can see that it’s not a matter of reacting to inflation, but rather  a matter of interacting with it. That’s why I take the approach of allocating  to portfolios based on the ways various sectors and/or industries can pass on their input price increases without affecting their bottom lines.

There are sectors such as basic materials, energy companies, and some growth companies that can do well during inflationary periods. Companies in the healthcare, financial, and some technology sectors are volatile in face of these changes as they have projected cash flows far into the future which make their value more susceptible to changes in interest rates.

This past week (ending 1/14/2020:

Energy (+5.6%) and basic material (+1.55%) companies rallied while other sectors, especially technology (-5.2%) and health care (-4.25%), sold off.

Energy and basic materials rallied due to both geopolitical uncertainties regarding Ukraine and inflationary pressures that are still lingering due to COVID disruptions. 

Year to date:

The theme of the year so far is a rebalancing away from Technology and healthcare companies which performed so well in 2021 and towards more value-oriented companies in the energy, consumer staples, and basic materials sectors.