- - Monday, June 30, 2014

ANALYSIS/OPINION:

Benjamin Franklin is credited with saying, “Nothing can be said to be certain, except death and taxes.” There’s a third certainty in life, however: inflation.

True, there have been brief periods of time when the prices for goods and services fell (i.e., experienced deflation). The most notable of these were after the stock market busts of 1921 and 1929, and again following the Great Recession of 2008. Outside of these rare occurrences, inflation, which is defined by Wikipedia as “a sustained increase in the general price level of goods and services in an economy over a period of time,” has risen steadily in the United States during the post-World War II era. Since 1970, inflation has averaged nearly 3.4 percent per year, but there have also been periods when inflation was rampant; these most recently occurred in the mid-to-late 1970s and early ‘80s, when inflation rates were routinely in the high single digits and low double digits annually.

While inflation annualized slightly below 1.5 percent in 2013, in recent months it has been edging higher. This is a bothersome trend. According to the Bureau of Labor Statistics, inflation on a national basis increased at a 2.1 percent annualized rate in May. For the Washington-Baltimore area, the rate was slightly higher, at 2.2 percent.

Forecasting the prospects for inflation in the years ahead is critical for individual investors, especially for baby boomers facing 20, 30 or even 40 years in retirement. Aside from the freedom, retirement means living on a fixed income. Corporate pensions are a thing of the past, and the cost-of-living adjustment tied to Social Security payments is widely thought to be understated. Even worse, health care costs have risen much faster for seniors than the Consumer Price Index over the past few decades.

Except for those who have retired from a life of public service with a guaranteed pension, few retirees will have the luxury of knowing with certainty that their income will rise over time and keep pace with inflation. Thus, most boomers will be heavily reliant on their retirement savings to sustain their standard of living. This is — or should be — a scary proposition, especially for Washington-area residents, where inflation tends to be slightly higher than the national average.

The dangers of inflation are real. At an annual inflation rate of just 2.0 percent, a retiree’s standard of living (i.e., purchasing power) will be cut in half in approximately 36 years. However, using the long-term average of 3.4 percent, purchasing power is cut in half in only 20 years. Inflation is a major threat to one’s lifestyle in retirement, and underestimating inflation could be a costly financial mistake.

How likely is it that inflation will rise in the near term? According to a March report by the Federal Reserve Board, the personal consumer expenditures — the Fed’s preferred measure of inflation — is expected to rise from 1.6 percent to 2.2 percent by 2016. Other estimates from investment behemoths such as PIMCO Investments are consistent with this range — 2 percent seems to be the number most often cited — and are equally consistent with research from Carmen Reinhart and Ken Rogoff in their book “This Time Is Different,” which showed that a slow-growth economic environment typically follows financial bubbles, such as the Great Recession of 2008. Today, our economy is characterized by stagnant wage growth, slow bank lending, and little, if any, pricing power on the part of corporations. Collectively, we have below-trend gross domestic product growth on a global basis and a consensus forecasting low inflation over the balance of the decade.

The likelihood of inflation rising rapidly in the near term seems low at present, but the financial markets have a way of doing the unexpected. Thus, the question is not if, but when inflation will rear its ugly head.

Timing aside, the issue at hand for baby boomers is striking an asset allocation that provides protection against inflation. Historically, hard assets, such as real estate, commodities and precious metals, tend to provide better real (after-inflation) returns than financial assets, such as common stocks and bonds. Common stocks of well-run companies, which have the ability to pass along price increases to their customers at a profit, also tend to fare well during inflationary periods. Fixed-income assets, which play a meaningful role for investors seeking income and diversification, fare the worst by comparison.

The danger of inflation is real, so forget trying to predict the likelihood and the “when,” and make sure your portfolio is properly diversified. Above all else, practice disciplined rebalancing each year. That’s what matters most.

W. Kirk Taylor is principal and chief investment strategist at 1st Portfolio Wealth Advisors.

LOAD COMMENTS ()

 

Click to Read More

Click to Hide