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Portfolio > Economy & Markets > Economic Trends

Advisors, It’s Time to Dust Off the Inflation Playbook

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What You Need to Know

  • Equities — particularly those that pay steady dividends — tend to perform relatively well in periods of high inflation.
  • For clients with the stomach to stick to their long-term financial plans, taking excess cash and dollar-cost-averaging into the market over the next 12 to 24 months may be a sound strategy.
  • Holding fixed income is almost certainly a losing game.

For more than a year, we’ve been ringing the alarm bell on inflation. While the Federal Reserve’s decisive rate cuts in 2020 almost certainly helped prevent an economic collapse, by the spring of 2021 we began making the case that the Fed needed to start raising interest rates to offset the inflationary pressures that were bound to emerge as the lockdowns associated with the COVID-19 pandemic receded.

Through monetary policy, fiscal policy and reduced consumer spending, bank balance sheets swelled by nearly $5 trillion, from $13.3 trillion in January 2020 to $18 trillion by December 2021. This unprecedented increase in the money supply drove interest rates to near-zero and created asset bubbles in real estate, equities, cryptocurrencies and nonfungible tokens. After all, with so much new cash to deploy and a cost of funds approaching zero, this money had to go somewhere.

Financial advisors struggled to keep clients from chasing the latest mania in search of outsize returns — returns that were driven by nothing more than momentum and a huge imbalance between supply (of investable assets) and demand (driven by excess liquidity).

Pent-Up Demand

In early 2021, the Fed was resolute that it wouldn’t need to raise interest rates until 2024 at earliest. By the summer, signs of inflation were deemed “transitory” and even in the autumn of 2021, few Wall Street analysts expected any significant movement in interest rates.

We disagreed. Our view — informed by countless conversations with banks and our own experience living through multiple market cycles — suggested that the surplus in deposits could quickly swing the other way as consumer spending resumed and pent-up demand for travel and entertainment would mean that far too many people would simultaneously be seeking far too few airline seats and hotel rooms.

According to Wayne Best, chief economist at Visa, high-net-worth households are sitting on $250 billion of pent-up spending demand — that’s a lot of people booking European vacations with minimal price sensitivity.

In the first few months of 2022, depositors burned through a few hundred billion of cash, and as inflation takes its toll on the households least equipped to withstand it, more of this surplus liquidity will evaporate. In the past four weeks, the banks with which we speak regularly have flipped from worrying about excess liquidity to worrying about how they will fund a big uptick in loan growth.

As the cycle continues, we’ll begin to worry about asset quality, as inflation is bound to drive an increase in defaults. The rapid growth in buy-now-pay-later (BNPL) schemes remind us of the dangers inherent in this new form of “layaway” financing. As the credit cycle advances, consumers will also feel the impact of an increase in rates on variable rate mortgages and revolving credit lines, coupled with the job losses that are likely to emerge as the economic growth slows.

The Fed’s 0.75% rate increase in June didn’t come as a surprise to us; we’ve long held the view that the Fed will need to raise rates more aggressively to curtail aggregate demand and rein in inflationary pressures. But with continued upward revisions in expectations around the federal funds rate, there is seemingly no end in sight. What’s clear is that the Fed is significantly concerned about inflation rising higher and lasting longer than they had anticipated even a few months ago, and we expect interest rates to follow suit.

The Inflation Playbook

So, what does this all mean for financial advisors and their clients? Which asset classes perform well in periods of high inflation? Which asset classes will suffer? How can advisors best keep clients on the right path? It’s time to dust off the inflation playbook.

Despite their sensitivity to the discount rate, equities tend to perform relatively well in periods of high inflation. Most companies are ultimately able to pass along increases in input costs in the form of higher prices, and so nominal stock prices can keep pace with inflation. But some firms are better positioned than others. Those that pay steady dividends will find support in their dividend yields, while younger technology companies that generate losses in exchange for the promise of future cash flows will be penalized by the market.

Fortunately, most recessions last less than 18 months, so for clients with the stomach to stick to their long-term financial plans, taking excess cash and dollar-cost-averaging into the market over the next 12 to 24 months may well prove to be a sound strategy for long-term value creation.

By contrast, holding fixed income is almost certainly a losing game. With rates poised to rise continuously for a while, bonds will continue to lose value. The longer the duration of the bond, the more it will fall in price as rates rise. Short-term fixed income strategies are likely to perform better than bonds. With rates rising so quickly, same-day-liquid high-yield savings accounts are likely to outperform CDs, while simultaneously affording clients more flexibility to invest opportunistically. For clients holding cash (and nearly all clients hold meaningful levels of cash outside of their investment portfolios), it’s important to make sure that cash is earning as high a yield as possible.

If you believe that we’re still in the relatively early innings of a longer period of inflation, real estate can still be an attractive asset class. If you’re able to avoid regional market bubbles, nominal real estate prices ought to generally keep pace with inflation over time.

In addition, in a rising rate environment, locking in a relatively low rate mortgage can help clients multiply the benefits of real estate ownership, as the real value of their mortgage debt will decline in an inflationary environment at the same time that the nominal value of their property is increasing.

Private equity is probably the real winner in times like this. Private equity firms have the flexibility to invest with a longer time horizon. While an industrial company might typically be valued at eight times cash flow, private equity firms can often pick up a company during the low point in a business cycle for six times (diminished) cash flow, and later sell it for ten times (peak) cash flow at the top of the cycle. This “time arbitrage,” coupled with some leverage and injection of operational best practices, is what enables private equity firms to deliver high-teens returns across a typical 10-year investment period.

Key to a client’s ability to lock up capital for this long is holding a cash cushion that enables them to sleep soundly at night without worrying about the illiquidity of their private investments. To a lesser extent, the same can be said about equities: A client who holds a few years of living expenses in cash is less likely to panic and want to sell their stock portfolio at precisely the wrong time.

Advisors play an important role in helping clients weather storms. Clients will take comfort knowing that their financial plans have been constructed to withstand the current macroeconomic environment.


Gary E. Zimmerman is the founder and CEO of MaxMyInterest, a solution that helps clients earn higher yields on cash in FDIC-insured savings accounts.

(Image: Adobe Stock)