Recently in this space, I've been highlighting topics advisors are hearing plenty about this year. Rising interest rates and the impact on fixed income allocations chief among them.
A related subject – another one advisors are dealing with more and more in 2021 – is rising inflation. Advisors know all too well the adverse effects rising consumer prices can have on client portfolios and that this issue is of particular importance for clients in or nearing retirement because inflation places an elevated premium on generating adequate income – something that's tricky to do in today's low-yield environment.
While the way the consumer price index (CPI) is calculated leads to ample debate – leaving out food and energy costs skews inflation lower – the fact is the CPI is perking up in meaningful fashion. Rampant government spending, more of which could be coming, a weak dollar and a suddenly hot U.S. economy are among the factors driving the CPI higher.
With that information in hand, it's an appropriate time for advisors to stay abreast of base effects – nuances that explain dramatic increases in GDP growth and other economic activity.
Exploring Base Effects
On the surface, base effects appear to be a wonky term reserved for trained economists. I won't argue that point, but advisors should gain at least a cursory knowledge of this concept. Clients could end up thanking them.
“Base effects help mask the reality that activity hasn’t yet reached pre-pandemic levels in most of the world, that labor markets are still notably lagging despite recent strength in some places, and that the threat from the disease itself remains high, especially in emerging markets,” notes Vanguard's Joe Davis. “These amplified comparisons to previous weak numbers portray a U.S. economy going gangbusters. Inflation is the next indicator to be roiled in this way.”
Base effects coupled with factors such as rising commodities prices and supply shortages of vital goods – looking at you, semiconductors – could portend CPI upside.
“It’s quite possible that base effects, as well as supply-and-demand imbalances brought about by the pandemic, could help propel the U.S. Consumer Price Index (CPI) toward 4% or higher in May and core CPI, which excludes volatile food and energy prices, toward 3%,” adds Davis. “All else being equal, we’d expect inflation to fall back toward trend levels as base effects and a shortfall in supply fade out naturally.”
Advisors: It's Time Play Psychologist
As Vanguard's Davis notes, one of the persnickety issues associated with inflation is that investors get it stuck in their minds that it's coming and it has a way of manifesting itself into, well, more inflation.
“That inflation expectations could have a self-fulfilling nature shouldn’t come as a surprise. As individuals and businesses expect to pay higher prices, they expect to be paid more themselves, through increased wages and price hikes on goods and services,” notes Davis. “Fears of a self-perpetuating wage-price spiral are understandable, given the experience of older investors with runaway inflation in the 1970s. But many of the factors that have limited inflation, notably technology and globalization, remain in force. And we expect central banks that will welcome a degree of inflation after a decade of ultra-low interest rates will also remain vigilant about its potentially harmful effects.”
Advisors can talk clients off the metaphorical inflation ledge by highlighting tried and true strategies for beating rising consumer prices. Getting ahead of the game is also a source of positive reinforcement with clients. With that in mind, it could be about a year before core CPI tops 2%, indicating advisors can prove their mettle by talking inflation strategies with clients today, not in 2022.
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