First off, this post is for information only. If you are a Town Capital client, we are already taking care of the issues we are discussing in this email. If you are not, call us, or call your advisor and ask what their plan is. This is not investment advice.
I was in a restaurant the other day, and there was a sign on the front door about the price of chicken wings. It warned that due to a national chicken wing shortage, the price of wings would now be listed as a MARKET price, and you had to ask the server for the current price when ordering. Chicken wings…up there with Lobster and Chilean Sea Bass.
So, I did. They were selling for about $1.45 per wing.
What caused this? Is it an increase in demand for wings during the pandemic? Are less chickens being produced for wings? Was it the chicken sandwich war between Popeye’s and Chic-fil-A?
Maybe. Probably not.
But what about the prices of other goods? Anyone who has built a home or completed a home improvement project recently will tell you about the price of lumber right now. In some places in the country, wood is 5x more expensive than it was pre-pandemic.
This is inflation. The cost of good going up. The value of your dollar going down. Supply and demand.
Economists use the broad increase (or decrease) in prices of goods and services across the country as a measure of economic health. When inflation is stable and predictable, it is a sign of a basically healthy, growing economy.
But, high inflation can quickly eat away at the purchasing power of your dollars, indicating that the economy might be overheated.
The Consumer Price Index (CPI), one of the major indexes economists use to track inflation, showed a surprising spike in April, igniting fears of runaway inflation.
Core CPI (which excludes the highly volatile categories of energy and food) showed a 0.9% increase in April month-over-month and 3.0% year-over-year. That’s much higher than the expected 0.3% and 2.3%, respectively.
There is a lot of talk on the news and financial shows that this is a warning that the inflation train is coming. Some, however, say it is only transitory. The government is denying its existence. I’d argue it is already here, and will be for some time.
One of the easiest ways to confirm if inflation is (actually) happening is the price of commodities (corn, beef, oil, wood, etc) as an aggregate.
Ever seen the movie Trading Places with Eddie Murphy and Dan Aykroyd? That’s right, we’re talking pork bellies and frozen orange juice.
Below is a chart of the Invesco Commodity ETF for the past year.
It’s almost doubled.
I think we can all agree at this point that inflation is happening, and you can see it in your everyday life. Inflation, in my opinion, is the biggest risk to a retirement (if unmanaged). Most think it is a recession, depression, or low returns, but back testing specifically proves that balanced portfolio can survive this with proper withdrawal rates.
Courtesy to Hedgeye for the picture above, we love them.
So, what’s the big deal? Is there another force acting upon us?
Yes…interest rates. Historically low rates to be precise.
So, what do interest rates have to do with it?
Well, most retirees, if they have constructed a proper portfolio, should have some allocation to lower volatility assets like cash, government bonds, corporate bonds, etc. This is to serve as a bucket to withdrawal from regularly, giving time for stocks to grow. It is also a buffer to prevent selling stocks while they are down, giving them time to recover after market drops. The benefit of bonds for the past few decades is that they have served as an important contributor to income.
Those days are gone, at least for a while. Remember, this all comes in cycles, and it can all be managed. The most damaging thought in finance: “This time it’s different!”
Stock have returned an average of 10.2% since the stock market’s inception, while bonds have returned and average of 5.4%. These numbers are debatable due to record keeping, but let’s take them with a grain of salt.
Sounds great…but these are paper returns. If you consider inflation, say at an average of 3% per year, we can say stocks return about 7.2% and bonds 2.4%
So generally, through history, bonds have served a purpose of not only lowering volatility, but providing returns in excess of inflation and better than a savings account. However, with interest rates at historically low values and the government providing stimulus and endless loan programs at near 0% rates, companies don’t really need your money anymore.
So, they are not willing to pay much for it. In fact, most bonds rates have fallen below 1%, which means they will lose ground when faced with even normal inflation, yet alone high inflation.
So, what can we do about it?
Bottom line, this is a manageable problem, but we must be smart. Below is a list of bulleted points that describe the actions we are taking at Town Capital. If you are not a client, these are not recommendations (we don’t know your specific needs), but you should call us or talk to your advisor about it.
Preferably, call us.
- First, do not ditch the bonds. Not completely, at least. They are still important to lower your portfolio’s volatility. Plus, increasing your equity exposure at the height of the market is a horrible idea. Just make sure you own the right types of bonds. Keep the bond duration short to minimize interest rate risk, keep a higher allocation to a floating rate fund, own TIPs (Treasury Inflation Protected Securities), and do not under any circumstances allocate too much to Junk bonds in search of yield. Ask people how that worked out in 2008. Not good.
- Second, own stocks, There is absolutely no better way to keep up with inflation than to have at least some portion of your portfolio in equities. Being too conservative in a high inflationary environment can deplete your nest egg too quickly.
- Own the right types of stock and keep a balance. Inflationary environments and rising interest rates typically fair better for value stocks vs. growth. Swinging too far in one direction can lead to years of underperformance. Make sure the value side is made up of quality, dividend paying companies. Cheaper is not always better, some stocks are cheap for a reason. The reason is…they are garbage. Also, right now, we like energy, financial, industrial, and material stocks.
- Look for alternative investments. Private equity, real estate funds, and liquid alternatives are a few ideas that can diversify your portfolio and provide more income than current bond rates, without taking on the additional risk of more equities.
- Take a look at structured notes. They are complicated products, so talk to an advisor about it. They have a payout structured similar to bonds but are linked to securities. I like to think of them as short-term, no commitment annuities. The best part, they have a defined outcome, so you can calculate their exact return under any market conditions.
- Take advantage of the down dollar. Certain types of international stocks have performed very well with the devalued dollar. If you are selective, profiting from the weakness of the dollar can help provide some inflation buffer.
Bottom line: Expect the unexpected in 2021, but be prepared for it.