The “American Rescue Plan” will bring a return of inflation
And why bonds may be a bad bet
With the passage of the $1.9 trillion relief package, prominent economists are expressing concern that the risk of inflation may now move even higher.
“There’s a real possibility that within the year, we’re going to be dealing with the most serious incipient inflation problem that we have faced in the last 40 years,” said former Treasury Secretary Larry Summers.
At a minimum, the fear of inflation is front and center of the current economic discord. The questions that come to mind are: Will we have it and when? How will it impact us? How much inflation are we likely to see? Was this even considered prior to the approval of one of the largest stimulus packages ever? These questions give investors and consumers angst; after all, inflation is rarely a good thing.
When the costs of the goods and services we buy every day are increasing, our income needs to grow, preferably at a rate higher than inflation. Inflation is like a headwind everyone faces; you may not feel it daily, it is subtle. Over an extended timeframe it is powerful.
Bonds or fixed-income investments are impacted the most during times of rising interest rates. A bond essentially promises to pay an interest rate and repayment of the loan at a particular time in the future. You bargain on the rate and the maturity date and receive fixed payments for the bond’s life. The trouble with that approach is the “fixed” part. Fixed cannot and does not increase over time.
Furthermore, when interest rates rise relative to the rate of your bond, the market value declines. Investors are about to see this in their investment statements as interest rates have risen dramatically recently. The U.S. Treasury 10-year bond has risen from 0.50 to 1.50%. People will look at their bond holdings, either mutual funds or individual bonds, and likely see their prices have fallen. Most people think bonds are “safe.” They are about to get a lesson in fluctuations they thought only applied to stock investments.
Investing in the stock market can be a great way to hedge against rising inflation. Since 1929, the stock market has gained around 9% per year while inflation averaged about 3% per year. Combine this approach with a strategy focused on dividend-paying companies, and you have a practical method for growing income that outpaces inflation.
Over the last 93 years, dividends have grown roughly 5% per year, and corporate earnings have grown at 5% per year. The price you pay for this approach is increased volatility. The price of stocks tends to swing more widely than bonds, but this is irrelevant for long-term investors and especially those who live off dividends.
It is critical to note that people do not live on their investments’ current price; rather, they live on the income generated by their investments. Individuals don’t spend the value on the statement; they spend the dividend income.
The other hedge we often hear about is gold. The challenge with gold is it is difficult to handle, divide, or use for anything other than speculation. You buy gold at a specific price and hope to sell it to someone else at a higher price. It is price speculation. It does not pay a dividend; instead, if you have someone hold your gold, you pay a custody fee. That’s a reverse dividend! You pay them to hold it for you. It does not generate income; it costs you to keep it.
Given our current environment, investors are wise to position themselves with ample cash (generally risk-free) and invest in businesses that will grow their dividends and earnings during a time of rising inflation. It may seem odd to think about cash as an investment class, but cash will conserve your principal during a time of rising interest rates while bonds will experience declining price or value. Blending a long-term asset class like stocks with cash in a portfolio can make a decent hedge against inflation.
While we can’t state with certainty that our economy will experience runaway inflation, many knowledgeable economists have foreshadowed it. No one knows for sure; however, we expect to see financial service companies and product manufacturers create products that are “designed to protect” investors from the ravages of inflation. Products like this are often complex and confusing. Simplicity often is a good strategy.
Invest in growing dividend companies and keep your cash reserves higher. If the U.S. experiences the predictions of rising inflation, financially this could be a better option than buying or holding bonds.
Securities offered through LPL Financial, Member FINRA/SIPC.
Steve Booren is the Owner & Founder of Prosperion Financial Advisors. Steve Booren founded Prosperion Financial Advisors in 1996. Since then, he has grown the practice to one of the top 20 largest financial advisory firms in the Denver area. Utilizing his 40+ years of investment experience, Steve authored the book, Intelligent Investing: Your Guide to a Growing Retirement Income, in 2019, and is a frequent contributor to The Denver Post on financial topics.