Inflation popped its head up in December for the first time in years. Is it a big deal or a big non-event? A little inflation at 2% is generally seen as a healthy metric for the US economy — far better than deflation — but what does it mean for your investments and spending? With inflation back on the radar, what can and should you do about it?
Maintain your spending. At low levels, inflation won’t affect your consumer spending or lifestyle. Wealthy people are impacted more by real estate prices and education costs than by the price of eggs and bread.
Keep your debt. Inflation can reduce the value of your outstanding debt (mortgages, etc). A family that holds a $1 million fixed rate mortgage balance during a time of 2% inflation effectively shrinks its debt obligation by $20,000 per year. As long as your interest rate is reasonable, it pays to hold debt during times of inflation.
Avoid holding too much cash. CDs and high-interest savings accounts can help. Even with those products, you may just be running in place. Picking a cash balance that fits your lifestyle and gives you peace of mind is more art than science. Keeping 12 to 18 months worth of expenses in cash is plenty. Anecdotally we see that many investors have a lot of cash on the sidelines right now – either because they’re waiting for the right moment or they chose not to re-invest while they were earning.
In your portfolio:
Hold on to equities. Stock returns tend to float over inflation. This is especially true over the long term where stocks beat inflation by a wide margin.
Avoid buying low fixed rates of return in the near future. If you buy a municipal bond portfolio paying 2% and inflation rises from zero to 2.5%, as it has recently, you end up with a locked in negative real annual return on investment of -.5% per year. That means you’ll have to accept a lower price when you’re ready to sell.
Expect higher GDP and earnings. These metrics will be lifted by inflation, creating a positive feedback effect. We are in a rare period where earnings and GDP are increasing around the world. Investors will adjust their numbers up by inflation. Seeing 3% or more GDP growth and 8% growth in earnings creates a positive psychological effect.
Call or email us if you’d like to discuss the role of inflation in your financial strategy. There is plenty more that was not covered in this article.
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