Inflation Report - April 2022: How can it affect your Investment Portfolio?

Inflation in April 2022 has continued to increase, particularly in the United States and other developed markets. The primary inflation metric exceeded 8% for the first time in 40 years. Market reaction was muted, suggesting financial markets anticipated high inflation numbers.

Our analyst team have explored inflation deeper, breaking down the figures and asking questions to understand the rate of inflation, the nature of inflation, and how this may affect investment portfolios.

Inflation is the rate at which prices increase and is measured by looking at specific prices on an annual basis to see how much they increase. The primary inflation metric is the United States Bureau of Labor Statistics (BLM) “Consumer Price Index” (CPI). The US BLM release a range of different data sets.

We note that our team have only assessed United States inflation data here, as we are looking at inflation of the US Federal Reserve monetary policy and how this could impact markets and investors.

Concentrated vs. Broad Inflation

Here we examined whether inflation is “broad” or concentrated in specific areas. Inflation statistics can be skewed by unusual or seasonal price increases in concentrated areas. For example, used motor vehicles in the United States have had their prices inflate significantly since the Covid-19 crisis started, but this might not impact consumers at all if they do not purchase a used motor vehicle in the next few years. This is regarded as a temporary event because new car manufacturing was impacted significantly by microchip shortages, and the incorrect assumption in the auto industry that people would buy less cars in 2021, leading them to reduce manufacturing output.

However, CPI data series released in April reveal that inflation is still slightly over 6% when energy, food, shelter (i.e., rent), and used cars and trucks are removed from the data.

This means that even when prices which are theoretically linked to current or temporary events are removed there is still 6% price inflation.

Fluid vs. Sticky Inflation

Fluid or Sticky inflation refers to whether price changes are likely to “stick” or not. Some items such as fuel or energy have flexibles prices that can increase and decrease rapidly, which are “fluid” price changes. Other items such as real estate or rental rates are likely to only have slow price changes which do not decrease, which are “Sticky” price changes. When there are unusually large price increases across sticky asset classes, it means inflation is likely to be more ingrained.

The US Atlanta Fed (part of the US Federal Reserve system) releases a Sticky-Price CPI data set, which shows sticky prices have inflated by 5.8% on an annualised rate as of March 2022, whereas fluid prices have inflated by 49.8% on an annualised rate over the same period.

What does this mean for Investors?

Segmenting the data further showed that while headline inflation exceeds 8%, if anomalous price classes are removed (used cars and trucks, energy, food, shelter) it is still approximately 6%. If flexible price classes (items which are regarded as going up and down in price rapidly) are removed, inflation is still approximately 5.8%. Based on this information, inflation appears to both be growing in intensity, impacting the wider economy rather than specific areas, and it’s probably here to stay.

It is impossible to know with absolute certainty what will happen in the future in any context, and this equally applies to inflation. The facts suggest that the US Federal Reserve are likely to raise interest rates with the aim of reducing inflation. They have already started raising rates in 2022 and are likely to continue to do so.

What are the key take aways?

Firstly, cash holdings have declined in value by at least 6% over the last 12 months. This means a cash holding of USD $1,000,000 as of the 1st of April in 2022 only has the same purchasing power as $940,000 as at 1st of April in 2021. If $1,000,000 USD were invested in a 2.00% fixed bank deposit, it would now be worth $1,020,000, which as of 1st April 2022 only has the purchasing power of $960,000 as of 1st April 2021. In the last 12 months, holding cash has effectively led to a 6% loss in terms of what the money can buy.

Secondly, investors need to consider how inflation can affect their financial plans. The cost of living has effectively increased by between 6% and 8% in the last year. This means a retirement planned around having $2,000,000 in cash would now require an extra $120,000 to $160,000 to secure.

Thirdly, it is particularly important for investor portfolios to be positioned to do well in the current market environment, and investor wealth structures to be set up to make use of tax advantages which become especially important in an inflationary market.

It is important to note that capital gains taxes in most instances do not take inflation into account, so an asset can increase in face value significantly, and attract a tax bill upon disposal, while still not gaining any real value in purchasing terms due to inflation.

Melbourne Capital Group’s Private Wealth team specialise in helping construct bespoke wealth structures which can have significant tax advantages and creating investment portfolios which are forward thinking and designed to seize opportunity in the markets while avoiding the problems of inflation.

Contact us now for more information.

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