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Inflation: Is It Time to Worry Again?

Second Quarter 2021

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

– Sam Ewing, former major league outfielder

A little over a year ago, the U.S. economy was shut down virtually overnight due to the coronavirus. Stocks sold off sharply, with the S&P 500 Index collapsing in a matter of weeks. Twelve months later, stocks have completely recovered and hit new highs, and Wall Street appears to have shifted its focus from the reopening of the economy to the threat of inflation, as inflationary concerns have dominated headlines since late January.

Stepping back, the Federal Reserve has two mandates:

  • To maintain stable prices.
  • To maximize employment.

The Fed seeks to achieve these goals through monetary policy – controlling interest rates and the money supply in an attempt to foster stable economic growth. The primary tool at the Fed’s disposal is the Federal Funds Rate, which is the interest rate at which banks lend to each other overnight and a proxy for other interest rates, such as the return on cash reserves in money market funds. In setting interest rates, the Fed hopes to influence the demand for money; lower interest rates may spur demand and economic activity, while higher interest rates may have the opposite effect.

Last summer, as the pandemic raged, the Fed articulated its most significant shift in policy in decades. It would focus almost exclusively on its employment mandate by keeping rates lower for longer, even at the risk of letting inflation exceed its long-stated goal of 2%. And with good reason—U.S. employment is still roughly 8.5 million jobs below the peak of February 2020.

Why is the Fed ignoring inflation for now? Why, in fact, does the Fed want a little inflation? After all, over time, inflation reduces how much a dollar can buy. Wouldn’t zero inflation be preferable?

One answer is that if consumers expect prices to rise in the future, they may choose to spend now, stimulating economic activity and thus employment. A second, more self-serving answer is that a little inflation prevents deflation, which can be far more damaging to long-term economic growth. With deflation, consumers expect prices to fall in the future and so they put off purchases until later, leading to a contraction in economic activity, which can initiate a vicious cycle. This is what occurred during the Great Depression. It’s also, more recently, what has happed to the Japanese economy. As deflationary expectations have now ingrained themselves in generations of Japanese consumers, this mindset has led to stagnant economic growth since the 1980s.

Getting back to 2021, many Wall Street strategists believe the economy is at risk of overheating in the next 12 to 18 months, an outcome which would force the Fed to raise interest rates sooner than planned. They cite the fact that:

  • Vaccines are becoming more widely distributed, allowing consumers to anticipate life returning to some sense of normalcy,
  • Household balance sheets, thanks largely to stimulus checks, including the latest round by the Biden administration, are in excellent shape and portend robust consumer spending, and
  • Corporations are responding by rehiring workers and rebuilding inventories and supply chains.

All of this points to possible significant economic growth the likes of which hasn’t been seen in decades—growth which many fear could be inflationary.

Mitchell Sinker & Starr has been consistent in our belief that a short-term, temporary increase in inflation may be inevitable due simply to the fact that pent-up demand and strong household balance sheets (see graph below) may create massive short-term demand. However, any inflationary effects are likely to be temporary, as an anticipated surge in consumer spending would be a one-time event on the way to a more normalized economy. After all, pent-up demand is finite and so is the extra cash consumers have on hand. Americans may buy more for a time but are in no position to reset the dial on spending in the long term.

Which brings us back to the Fed and inflation expectations. We do not believe that out-of-control inflation like that experienced in the 1970s is imminent and, hyperbole aside, there is little evidence to support such claims. The Fed has many tools available to ensure prices do not spiral too far beyond its comfort level. However, we believe it is reasonable to expect that the Fed may be forced to raise interest rates before 2023, which is its current expectation. We would note that historically the Fed has both over- and under-reacted to economic signals, for instance, leaving interest rates too low preceding the tech bubble of the 1990s and housing bubble of the early 2000s.

Inflation expectations are important for equity investors to weigh because interest rates are used to discount future corporate earnings, which drive stock valuations. Said another way, investors can justify paying more for stocks when interest rates are low, but when rates rise, overpaying for future growth becomes less attractive. As we head into the summer with cautious optimism, our focus will be on how the companies in our clients’ portfolios will navigate these issues, and whether their current stock prices accurately reflect a rapidly changing economic environment.

Mitchell Sinkler & Starr

Note that at the end of this Commentary we have included our second Investment Insights column. This quarter we discuss compliance and one of the most infamous financial villains of all time – Bernie Madoff.

 

Economic and Capital Markets Data

 

U.S. Total Employment – Fifteen Years

Despite the quick rebound from May of last year, additional economic growth will be required to recover the remaining 8.5 million jobs lost since the start of the pandemic.

 

Economic Data Points – Fifteen Months

In the U.S., economic activity has picked up as daily COVID-19 cases have declined from the January peak and vaccines have become more widespread.

 

Total U.S. Monthly Compensation & Unemployment Benefits – Fifteen Years

Total monthly compensation remains above pre-COVID levels primarily due to ongoing government stimulus measures.

 

U.S. Treasury Yield Curve – Two Years

Driven by inflation expectations, the pandemic-induced collapse in yields on government bonds has partially reversed, as long-term Treasuries now yield as much as they did pre-COVID-19. Short-term Treasury rates, however, remain far lower than they were 15 months ago.

 

Standard & Poor’s 500 Index – Five Years

Stocks climbed higher in the first quarter of 2021, as the pace of vaccinations increased and the economy showed additional signs of reopening. Unlike 2020, the upward move was driven by broad assortment of stocks in all sectors, rather than a handful of the largest technology companies.

 

Standard & Poor’s 500 Index – Sixty Years

Over the long-term, stocks remain the only liquid asset class with the potential for growth in excess of inflation.

 

Decade-by-Decade Market Return Data

 

View entire commentary as a PDF

Investment Insights

Lessons from Bernie: A Culture of Compliance and Why It Matters

As an SEC-Registered Investment Advisor (RIA) held to a fiduciary standard, Mitchell Sinkler & Starr has always had a strong compliance program. The role of compliance changed significantly, however, in 2008. That was the year that Bernie Madoff became a household name. Responsible for the largest Ponzi scheme in history, Madoff bilked investors out of at least $20 billion over decades and was sentenced to 150 years in jail in 2009.

Despite multiple warnings, the SEC failed to catch Madoff until it was too late. We should note that their resources are limited. In 2020, the SEC conducted roughly 3,000 RIA exams. While this may seem like a large number, it was only 15% of the total number of registered advisors. As a 50-year-old firm, Mitchell Sinkler & Starr has undergone two comprehensive SEC exams in the past 20 years that resulted in requests to improve a few areas of our compliance program, which is the point of these exams. But some firms have never been examined. And when the SEC knocks on your door (actually, they send a letter), it is too late to establish a compliance program—it had better be up and running already. Common sense, right? The SEC even provides a study guide by announcing their focus for the calendar year. For 2021, this includes:

  • Protecting retail investors and seniors, with a focus on areas such as fiduciary standards, fees, and sales practices,
  • Compliance programs for RIAs that have never been examined, and
  • Information security and operational resiliency, including business continuity and disaster recovery plans (a little late, in our opinion).

Mitchell Sinkler & Starr believes that compliance is the responsibility of every employee at the Firm, and our culture of compliance is spearheaded by our Chief Compliance Officer and overseen by our Compliance Committee, which is made up of five of our nine full-time employees. Our clients may not realize it, because they do not interact with our compliance program in a direct manner, but on any given day, we

  • Follow well established procedures and controls when opening, closing or transferring accounts,
  • Verify the authenticity of any client request to disburse funds from an account,
  • Follow our best execution guidelines when placing client trades,
  • Protect our clients’ PII – Personally Identifiable Information,
  • Educate our staff regarding cyber security risks,
  • Maintain state-of-the-art firewalls, antivirus software, and back-up procedures as part of a comprehensive information technology program designed to protect the Firm from cyberattacks, such as ransomware, and
  • Review, evaluate, update, and file, in a timely manner, all required SEC forms and disclosures.

In addition to being prepared for the next SEC exam, Mitchell Sinkler & Starr annually engages our auditor to conduct a Surprise Exam, which is designed to verify, track, and trace cash deposits and distributions from a sample of client accounts. This program seeks to protect all the Firm’s accounts by statistically sampling transactions, much like the audit of year-end financial statements for any ongoing business. This required program is the direct result of the Madoff fraud, as his Ponzi scheme relied upon fictitious account statements that reflected the transfer of assets from client to client with no basis in reality. In Madoff’s world, a gain in one account was simply the temporary transfer of cash from another client’s account.

Our clients should feel confident that the combination of our fiduciary duty and our compliance program ensures that their assets and personal information are safe, and that each and every interaction and transaction we engage in on their behalf was done with utmost attention to their financial security and well-being at all times.

To the extent that you are responsible for keeping us even more vigilant than we were before, thank you, Bernie.