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Thoughts on Inflation – Part Two

| May 10, 2019
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Can we start by being nerdy for a moment? We promise it will be brief and not too painful.

Our last Investec blog explained that inflation, as measured by the Consumer Price Index (CPI), doesn't account for quality improvements in the items in the monthly inflation survey.

An example may help explain the concept. Assume a particular item, say a nice digital camera, has increased in price. Let’s assume the sole reason for the price increase is because of a quality improvement. (Assume it's better sensors or an improved lens.) If that camera is one of the items priced each month to calculate the CPI, the price increase won't increase the inflation estimate. The U.S. Bureau of Labor Statistics (BLS) measures price changes disassociated from quality changes.  A price increase (or decrease, for that matter) because of quality improvements is adjusted out of the calculation. But the camera still costs more.  If you buy it, you'll likely pay the full price, including the cost of the quality improvements.

The items the BLS adjusts for quality improvements include, among others, apparel and footwear, major appliances, televisions, photographic equipment, smartphones, and internet, cable, and satellite television services.1

OK—we're done with the nerdy talk. Back to the real world.

"So," you say, "this helps explain why some things are expensive despite official inflation being low. But what else does this mean for me?"

First, recognize that official inflation numbers and how much more you actually pay each year for what you buy probably will not be the same. Quality improvements may make some items more expensive (think housing and cars); other items may actually become cheaper with technological improvements (think computers).

Price increases for much of what you buy each month may be reflected in the official CPI, but don't assume that your budget will magically work each year based on increasing it by those numbers. You should use CPI as an initial estimate for much of what you buy.  But "official" inflation and your own "personal" inflation may be quite different.

In other words, depending on what you buy, you may find yourself with money left over at the end of the year. Or you may find the cost of your shopping basket of goods and services actually has gone up by more than inflation.

Let's assume your financial plan envisions a basic household budget that rises each year by inflation. Recognize that there's uncertainty on what inflation you'll actually experience. It will depend on the purchasing decisions you'll make. 

You're left with a couple of choices. You can reconcile yourself to the possibility that your standard of living may decline if the increasing cost of what you buy exceeds your inflation-adjusted budget and you want to stick to your budget. Your budget may not go as far as your aspirations if the cost of what you buy outstrips CPI.  You'll find yourself at the end of the year with more things to buy than what your bank balance and budget allow.

But you may spend your budget on items that actually don't go up in price as much as official inflation. You may actually find that the year ends before your money runs out.

How should you handle this dilemma? Some of us see a dilemma as bad news in and of itself.  How should we handle bad news?

Doctor to patient: "I'm afraid I have some really bad news for you, sir. In my opinion, you only have at most six months to live."

Patient to doctor: "That's horrible!  I want a second opinion!"

Doctor to patient: "Well, you're ugly, too."

You can pretend the dilemma doesn't exist—assume that you'll always have money left over if you stay within your budget. Or you can assume that you'll likely have to reduce your spending, compromise your standard of living, to take care of price inflation.

Or you can try to deal with the dilemma by watching your spending during the course of the year and investing to outpace inflation. Consider the following:

Over the long haul, stocks of great companies in the U.S. and around the world have managed to provide returns in excess of inflation far better than have bonds or other fixed-income investments.

From March of 1989 to March of 2019, the Consumer Price Index in the U.S. more than doubled, going from 122.3 to 254.202.2 What cost around $100 in 1989 cost somewhat more than $200 in 2019, looking at the market basket of goods and services as a whole. On an annualized basis, inflation grew at a rate of 2.47%, compounded over 30 years.

The S&P 500 stock index, measuring stock prices of leading large companies in the U.S., went up almost 10 times from its level in March of 1989, from 292.35 on March 29, 1989 to 2,834.40 on March 29, 2019.3 Annualized returns for the S&P 500 over this 30 year period were 7.8%, compounded annually. And that's ignoring the value of dividends on the stocks in the index. If you reinvested those dividends, your annualized return is slightly more than 10% per year, compounded over thirty years.

Yes, investing in stocks can be scary because prices go up and down. But the evidence still suggests that they’re your bet if you want a chance of outpacing inflation. If you want to sustain your standard of living or perhaps even afford the quality-improved products the market place continues to offer, a portion of your portfolio needs to be invested in the stocks of great companies in the U.S. and around the world.  Returns may not equal those of the last 30 years, but stocks have a long track record of beating inflation.

And if you're concerned whether your portfolio is invested appropriately, give us a call. We'd be happy to offer a second opinion. (And we won't tell you you're ugly!)

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1https://www.bls.gov/cpi/quality-adjustment/home.htm

2https://data.bls.gov/cgi-bin/surveymost

3https://finance.yahoo.com/quote/%5EGSPC/history?period1=606981600&period2=1553835600&interval=1d&filter=history&frequency=1d

4https://dqydj.com/sp-500-return-calculator/

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