Is the inflation we are experiencing transitory?  Or have we started a new era of inflation?  We think this is a question that should be on investors’ minds as they consider investment positioning, asset allocation, and how to think about long-term returns.  We believe there may be an element of truth to both stances.

The global economic shutdown due to Covid has no modern historic precedent.  We have never seen a complete shutdown of the supply chain, nor an attempt to restart it.  In an era of Just-In-Time production, inventories were seen as inefficient.  Now, we are rethinking this approach around the world.

Cars, houses, lumber, rental cars, semiconductors and even food prices are rising as we deal with shortages of these items.  Shipping bottlenecks, production backlogs and lack of supply have all caused a sudden run up in prices across the spectrum.

With time, we believe much of this will be resolved and there will be a normalization of pricing.  We may see some increase in cost, versus past price levels, but we believe prices may fall from their peak.  This is illustrated in the chart below of lumber prices year to date.

We think that prices may begin to slowly inflate from their corrected price levels.  Or rather, that the distorted pricing will revert, before growing at a faster pace than we have experienced in the past decade.

This is especially true for commodities. However, it should be noted we think this concept should exclude labor inflation as it could be real and just starting.  There is a shortage of workers across multiple industries.  It has been in our experience that labor costs do not rise and fall in the way commodity prices do.  Rising labor costs in an inflationary period are normally real and sustained in our opinion.  Though labor costs have been flat to weak for many years, it appears this component of long-term inflation could be real and sustainable in the future.

Are we predicting runaway inflation?  No.  However, we believe this could be the beginning of a period of slightly elevated inflation.  We are positioning the portfolio to be prepared for it from an investment stance.

One must not underestimate the strong deflationary effect of technology and its subsequent disruptions.  We believe this continues in the future, making the inflation we expect to experience, occur primarily in businesses where there are high inputs of labor and commodities.  But not where the benefits of technology make goods and services cheaper for consumers.

The likely investment outcome to our view is that both bonds and cash will have a negative real rate of return, making it a punitive holding for investors looking to buffer volatility.  The Federal Reserve has intimated that they will let the economy and inflation run hotter than they have in the past with an accommodative stance, meaning lower interest rates than historical norms.

If you believe rates will not rise, and inflation will run at a reasonable rate of 2-3%, then bonds have no real return and cash has a negative rate of return.  If you believe that rates rise, albeit slowly, then bonds will have a negative rate of return and cash will be a better place to be, though will still have a negative return, just less severe.

Could the sustained bull market in stocks simply be inflation in the value of publicly traded businesses and their future returns?  We think this may explain some of the strong sentiment and price action we have seen this year.

We note that earnings have been stronger than the markets anticipated, and future earnings estimates could prove to be too conservative.  Inflation affects earnings too, and they rise as a result, if pricing power is maintained.  We think this is what markets are looking forward too, and if so, stocks may be attractively priced at current levels.

However, we do believe stocks will experience volatility, and we view this as a normal part of a healthy market. But we think that stocks will likely be the only public vehicle for real, after inflation, returns over the next few years.

John C. Cheshire
Chief Investment Officer


[1] “Quarterly Review in Charts Thu. Jul 1, 2021”
[2] “Quarterly Review in Charts Thu. Jul 1, 2021”
[3] “Quarterly Review in Charts Thu. Jul 1, 2021”
[5] “Quarterly Review in Charts Thu. Jul 1, 2021”
[6] “Quarterly Review in Charts Thu. Jul 1, 2021”

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