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What Does the Current Bout of Rising Inflation Mean for Investors?

Some nonsensical things appear to be happening in the US investment markets. For example,

- We appear to be close to a recession, if not already in one. If so, it would seem that consumers would be spending less, leading to less demand. But if there is less demand, prices should be showing signs of falling. Instead, we have a case where prices, and therefore inflation, seem to be rising.

- And, as the likelihood that we may be entering (or already have entered) a recession continues recently to grow day by day, why has the S&P 500 Index not fallen further since mid-January? (The Index actually closed a tad higher on Feb. 29th than it was on Jan. 18th.)

- Finally, as the economy shows signs of growing weaker, why are some types of bonds, which typically do quite well during a slowing economy, doing just the opposite?

Being that I am not an economist, and that my newsletter is not really about explaining to the nth degree of detail how the economy works, I do not have clear answers to these things. However, we must remember that the US markets are highly integrated with happenings not only here but in the rest of the world. Food, commodity, and oil prices, for example, are subject to worldwide forces, as is the performance of our stock market. Even our bonds can be swayed considerably by investors outside our country who hold large swaths of them, especially US Treasuries.

For investors, I feel it is important to try to cut through the various cross-currents, always keeping in mind the basic long-term trends that seem to be in operation. Specifically, let's focus on the effect these more lasting trends may likely have on various types of mutual fund investments.


Over at least the last decade we haven't heard a whole lot about inflation until somewhat recently. Long-term bonds, thought to suffer most when inflation is a problem, have generally done quite well over the last 10 years. In fact, a 10 year investment in most intermediate and long-term bond funds would have done as well or even better than the S&P 500 Index! Of course, stocks are still recovering from the big hit they took during the bear market of 2000-2002, but that extended downturn had nothing to do with an outbreak of inflation.

But now as international oil prices have broken the once near unthinkable level of $100/barrel, we are also being hit by higher food prices. Inflation, if watered down by factoring out oil and food prices, still might seem to be only slightly elevated, but as these changes continue over multi-year periods, sooner or later, the overall price increases have to be recognized as presenting a danger signal to our economic well-being by our well-meaning, but sometimes less than totally candid, government officials.

In fact, overall inflation as measured by the Consumer Price Index has been trending up for the last 6 years! Back at the beginning of 2002, annual inflation was near just 1%. But ever since then, it has been bobbing and weaving upward, hitting over 2%, 3%, and now over 4%, with only a few temporary drops back below 2% in 2004 and 2006.

Obviously, higher inflation is not good. Unless this on-going 6 year trend can be reversed, there will likely be further ramifications, not only for Wall St., but for Main St. While the Fed can focus for the short term on lowering rates to try to prop up growth, they will be forced to re-focus on inflation as soon as some stabilization in US growth can be achieved. What this means is that instead of lowering rates, they likely will have to stop, and even reverse course, raising rates as their primary weapon against excessive inflation. While falling rates can sometimes, but not always, be a pick-me-up for the stock market (stocks have fallen significantly since the first 2007 Fed funds rate cut on Sept. 18th), rising rates will likely have the opposite effect.

It is interesting to look at a possible historical relationship between inflation and subsequent levels of unemployment to see whether our current bout of higher inflation gives an indication that unemployment may be affected as well. As it turns out, looking at data over the last 40 years, whenever inflation began to significantly rise, unemployment usually began to follow upward with a lag of a few years. Thus, if one considers 2005 as roughly when inflation started going considerably too high (over 4%), it is not surprising that unemployment started edging higher in 2007. And according to the data, the higher inflation went, the employment rate continued higher as well, also with a lag of a few years. The same appears true whenever the inflation rate fell: unemployment began falling too, also with a several year lag.

What this means is that it seems likely that the unemployment rate will continue to rise over the next few years, even if inflation can stopped in in tracks right now (which appears highly unlikely.) Bottom line: higher unemployment will lead to reduced consumer spending, both likely contributing to a longer than average (averaging being 6-9 mos.) period of recession. Please see the following graph for further confirmation.

And interestingly enough, EVERY recession since 1948 or earlier has occurred not long after the unemployment began rising, and additionally, ended shortly before unemployment started to fall back again. All of this appears pretty ominous to me since not only are we in the period during which unemployment has been rising for about a year now following inflation's re-appearance, but it does not appear that we are near the end of that rise. To the contrary, we appear closer to the beginning. Please see the following graph for further confirmation.

The last graph also shows the effect of recessions on the performance of the S&P 500. For those not familiar with economics, recessions are consistently not a good time for stocks, although stocks may wind up recovering quickly, even before the recession is over.


In spite of all the negative news about the economy over the last several months, it might appear as though stock market investors were already looking ahead to a recovery during late Jan. and most of Feb. After all, many economists and Fed officials are forecasting that the economy will start to return to better footing as interest rate cuts and the rebate checks to taxpayers ride to the economy's rescue. So the apparent strange behavior of the stock market, actually rising during the last month and a half, seems to reflect the fact that many investors consider right now a good buying opportunity. Since stocks typically begin to recover as much as 6 months or so before a recessionary downturn ends, this may be in fact why stocks have indeed leveled off (at least, up to now) from December and January's plunges.

But as Feb 29's selloff indicates, perhaps these optimistic investors should not be so sure that a rapid recovery from slow economic growth (or even a recession) is not very far off. Some of the most highly regarded experts we follow suggest that the current downturn could last easily into 2009 or even longer.

We have long suggested that investors should be aware of the long-term trend of a given investment category and not expect that trend to change rapidly once it has become well established over a full year or more. And what is the long-term trend for almost all categories of US stocks today? The S&P 500 Index currently is no higher than it was nearly a year and a half ago, and has actually dropped from where it was a year ago. Such sub-par performance is not a good sign for future performance and investors should not be ready to snatch up so-called "bargains" until the one year trend reverts from negative to positive and stays positive for many months, if not considerably longer.


All of the recessionary talk should be great for bond prices, and for the most part, it has been. Since the sub-prime crisis first came to the forefront last summer, high quality taxable short, intermediate, and long-term bonds have all done quite well, easily returning on average, at least 1% a month, or 12% total return or so when annualized. Of course, low quality bonds are a different story. As we warned our readers in July, 2007, high yield ("junk") bonds have not been a place to be, and are still not, because these kinds of bonds tend to falter when the economy slows, and investors are loathe to take on the kind of risk they might otherwise accept within a healthy economy.

But all this is not to say that even quality bonds, especially longer-term ones, are a safe place to be if inflation stays on the rise. Investors in the bond market will begin to sell bonds if they anticipate that their returns are no longer as valuable after inflation is factored in. And, of course, if traders anticipate ahead of the actual fact that the Fed will be forced to raise interest rates in the not too distant future to keep inflation from getting too high, they will do the same.

But what are we to make of prices for high quality tax-free municipal bonds, which have recently been dropping as fast as taxable quality bonds have been rising? There appears to be no economically sound explanation for munis recent poor performance, since muni bonds are a relatively conservative investment, rarely default, and should not have been logically been sucked into the sub-prime crisis either. As a result, muni bonds are now paying dividends that are equal or higher than comparable quality and maturity taxable bonds. Consequently, their after-tax return is considerably higher right now than available in taxable funds. In the past, such rare occurrences have been excellent buying opportunities for munis and that again appears to be the case today. In fact, given the seemingly dangerous prospects for stocks (especially U.S. stocks), and that US bonds may not have quite as good prospects ahead as they have already shown, beaten down mu nis may be one of the better fund categories available for good returns over the next few years. Couple this with the likelihood of higher tax rates in the future, especially if a Democrat takes over the White House (no disparagement of the Democratic candidates is implied), and the argument for munis becomes even stronger. But, given the rapid current deceleration in prices right now, I recommend waiting for prices to stabilize, or even to return to an upward trend, before establishing or increasing one's holdings in any major way.


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