How to Interpret the Inflation Headlines

Written by Edward Howison

How quickly things change.

Two years ago, the New York Times reported, “Federal Reserve officials are increasingly worried that inflation is too low and could leave the central bank with less room to manoeuvre in an economic downturn”. More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors; “Everything Screams Inflation”. The author, a veteran financial columnist, observed, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labour are all shifting to supporting inflation.”

Is inflation headed higher? In the short term, it has already moved that way. With many firms now reporting stronger demand for goods and services following the swift collapse in business activity last year, prices are rising – sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines enjoy full flights, and many restaurants struggle to hire sufficient cooks and waiters. Therefore, we should not be surprised that air tickets and meals out cost more than they did a year ago.

Do such price increases signal a coming wave of broad and persistent inflation or just a temporary snapback following the unusually sharp economic downturn in 2020? We don’t know. But future inflation is just one of many factors that investors consider. The market’s job is to take positive information, such as exciting new products, increase in sales, increase in dividends and balance it against negative information, like falling profits, wars, and natural disasters to arrive at a price that every day both buyers and sellers deem fair.

Let us assume for the moment that rising inflation persists into the future. Some investors might want to hedge against higher inflation, while others might see it as a market-timing signal and make changes to their investment portfolios. But for the market timers to do so successfully, they need a trading rule that directs exactly when and how to revise the portfolio— “I’ll know it when I see it” is not a strategy. A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.

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. Rinse and repeat.

The evidence of success in pursuing such timing strategies—by individuals and professionals alike—is conspicuous by its absence.

Some of the recent inflation concerns appear linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimise its importance. But these concerns are generally not new, and the expected consequences of these issues are likely already reflected in current prices.

The future is always uncertain, but a willingness to bear uncertainty is the key reason investors have the opportunity for profit. Investors will always have something to worry about. The possibility of unwelcome or unexpected events should be addressed by the wealth plans initial design rather than by a hasty response to stressful headlines in the future. Simply staying invested can help investors outpace inflation over the long term.

Source: Dimensional Fund Advisers, August 2021 

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