Inflation: Resurrection or Another Head Fake John Micklitsch, CFA, CAIA Chief Investment Officer

Just when you thought it was dead and buried, inflation, which is defined by the Oxford Dictionary as a general increase in prices and fall in the purchasing value of money, has re-entered the market narrative. Driven by the trifecta of fiscal stimulus, accommodative monetary policy and a potentially synchronized global economic recovery post-COVID, inflation is very much back on the minds of investors.

Investors fear inflation because it erodes real returns and reduces the value of future cash flows. Economists fear inflation because, if inflation rises too much or too quickly, it may require policy makers to slam the brakes on the economy by raising interest rates as former Fed Chairman Paul Volker did back in the early 1980s. Corporations fear inflation because it can eat into margins and earnings if they aren’t able to pass along price increases to their customers or if higher associated interest rates raise borrowing costs. Consumers fear inflation because it reduces their purchasing power and the value of their savings. About the only people who have made peace with inflation are some political figures who view it as the least-negative path forward following decades of excessive spending. Remember, nobody is ever on record casting a vote for inflation.

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But is there such a thing as good inflation or is all inflation bad? The answer, like most things in life, lies somewhere in the middle. When mild inflation is a sign of increased consumer demand or an economy that is getting back on its feet, a little inflation can be a good thing and a positive signal. When inflation is more aggressive or the result of bad policy, however, it can be harder to put a positive spin on the rising cost picture and, more importantly, it can be harder to control.

For much of the last three decades, the U.S. economy has enjoyed below-average inflation. This is despite the onset of deficit spending that started in the 1980s and has continued to the present. The lack of inflation or consequences has led many to promote a new concept called Modern Monetary Theory (MMT), essentially espousing that deficits don’t matter and that technology and higher taxes will keep inflation at bay. To us, this is a little like saying credit card debt doesn’t matter if the interest rate is low. Eventually, the rate may go up, then what?

Nobody knows for sure the form or magnitude inflation will take this time around, but it is certainly prudent, in our opinion, to assess your portfolio’s readiness and your personal planning needs considering the current potential for higher inflation. If such a review leads to a path of saving more and spending less, there are worse things that could happen to one’s financial foundation. If it leads to portfolio and planning adjustments that allow you stay on the offensive, even better.

Ancora has the planning expertise and investment strategies for dealing with a wide variety of market environments, including more inflationary ones. We invite you to engage with us about your questions, comments and concerns regarding inflation. Together, we can help ensure that neither inflation nor any other roadblock derails your long-term plans or your personal definition of investment success. ◊

The Effect of Inflation on Your Financial Plan Vanessa Mavec King Vice President, Financial Planner

Inflation is the quantitative measure of how quickly the price of goods is increasing. The most common measure used to quantify this is the consumer price index, or CPI, which is determined by tracking the weighted average price for a basket of goods. This “basket” is made up of consumer goods and services such as food, medical care and transportation costs. The price changes reflected in that basket of goods are meant to assess the changes in cost of living for consumers. When we build financial plans for clients, there are a lot of variables to take into consideration and many of them can be hard to accurately forecast. Inflation, and its role in a long-term plan, is a great example of this.

Over the past decade, inflation has been historically low, though this may be changing due to the unprecedented stimulus, monetary response and eventual global financial recovery from the COVID-19 pandemic. It is possible that inflation could begin to rise, which is meaningful as we plan for the future because inflation causes two harmful effects on one’s savings. The first is that increased inflation means that purchasing power is reduced at a quicker rate. The second is that, as future goals become more expensive because of inflation, more stress is applied to your portfolio to support those increased spending needs. For those reasons, it’s important that we stress test the impact of inflation when we run our financial plans. This can include adjustments in future spending assumptions or target balance accumulation objectives to build in higher margins of safety.

Another area of consideration when addressing inflation in the planning process is examining asset allocation and the impact that adjustments can have on the probability of success. As the value of a dollar declines over time, investing for growth provides much of the returns needed to maintain and even grow purchasing power. Even in the uncertain times we have seen over the past year, it’s important to evaluate your portfolio’s sensitivity to potential inflation increases and adjust your allocation where needed so that your investments can adequately maintain your purchasing power. Everyone has a different level of risk tolerance for adjustments like this, but understanding the proper mix of risk and growth assets that allow your plan to succeed, including the use of alternative investments, is essential. This measured approach is more important than ever as life expectancies have risen over time, leading to a longer timeline that our assets must fend off inflation and continue to support our lifestyles.

Every financial plan is built on unique and customized goals and expectations. Each case has a different need for risk and growth but, as we face global changes ahead, the impact of inflation will certainly continue to play a role in how we think about preparing for the future, our investments, expected real rates of return and risk.

If you would like to see the impact of different inflation scenarios on your specific situation, please do not hesitate to set up a meeting with Ancora’s planning team through your Relationship Manager. ◊

Inflation, Fixed Income and the Current Economic Backdrop Kevin Gale Managing Director, Head of Fixed Income

Inflation is not something favored by bond investors as it can lead to a rapid rise in interest rates, which can reduce the principal value of an existing bond. With the passage of the $1.9 trillion stimulus bill, investors are pricing in significantly higher growth expectations for fiscal 2021. Some economists predict Gross Domestic Product (GDP) could rise 8-9% by the end of 2021 as the stimulus takes effect. However, with the higher growth expectations comes higher expectations for inflation.

Since the financial crisis of 2008, the Federal Reserve (Fed) has been ineffective in creating inflation through its easy monetary policy, which has consisted of historically low interest rates and trillions of dollars in bond purchases into treasury bonds, mortgage-backed securities and, more recently, corporate bonds. Instead, the inflation that the Fed has created has primarily been in financial asset prices, including stocks and bonds, but not necessarily in wages or the final price of goods and services.

Is this time around different? Quite possibly it could be, but only time will tell. The market is currently pricing in an average inflation rate of just under 2.50% over the next five years. This is the highest level of inflation priced in the market since just prior to the financial crisis of 2008.

Why are many investors suddenly expecting higher inflation? On the production side, the simple answer is supply and demand. During the first few months of COVID, a lot of factories were completely closed or forced to work at significantly reduced capacities for several months. However, during the same time, demand remained high or even increased for a lot of products, especially home products such as furniture as people were at home staring at their outdated furnishings all day long. With trillions of dollars in stimulus money and Americans having extra money in-pocket with fewer day-to-day expenses, economic demand remained, just not across the board as consumer patterns changed. As a result, we have seen inflation in some areas but not others. That may be about to change as more of the economy comes back online.

Another area of potential inflation is in wages. Wage inflation could be spurred by the passage of a federal minimum wage increase and increased demand for workers. Since 2009 the federal minimum wage has been $7.25/hr. In the latest stimulus bill, lawmakers considered raising this to $15.00/hr. Though this increase was not included in the final bill, it is expected to be revisited. While many employers have already increased a high percentage of employee wages closer to the proposed $15/hr wage, some have not, especially in the fast food, hospitality and entertainment industries. The potential significant increase in minimum wage could have a

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Source: Bloomberg

5-Year Implied Inflation

profound impact on some prices as companies would likely increase prices to offset their increased costs.

One final consideration in the outlook for inflation is a recent change in how the Fed targets inflation. In September of 2020, the Fed changed the way it views inflation by moving to “average inflation targeting” over time. Officially, the statement said the Fed “will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time.” In the past, the Fed would begin to raise interest rates to try to prevent inflation from running too much above its absolute target rate of about 2%. Under the new averaging policy, the Fed could let inflation run “hot” if it believes it can maintain its 2% average long-term inflation target.

Inflation is an area of the economy that requires continued awareness as an investor and is something the economy has not experienced in over a decade. Unexpected inflation, the kind that defies policy controls, is something that can cause volatility in asset prices (stock and bonds). It is still unclear if the inflation we are seeing is transitory, due to the significant amount of stimulus benefiting the economy, or if it is a long-term issue. Traditionally, hedges against inflation include stocks, commodities, treasury inflation protected securities (TIPS), floating rate bonds, gold and certain real estate investments. Although it is possible that inflation could increase in the coming months, we do not recommend investors put all their eggs in one basket by betting that it will in fact happen. Ancora’s investment professionals continue to recommend investors maintain a well-diversified portfolio to help hedge against inflation but other unknown risks as well. ◊

Roundtable Q&A: Inflation from an Equity Investor’s Perspective Sonia Mintun, CFA Managing Director, Portfolio Manager

Q: Sonia, equities are said to be a good frontline defender against inflation. Why is that, in your opinion?A: With all the stimulus that has been implemented in the last 12-months. as well as more on the way, inflationary pressures are expected to build. Using history as a guide, equities tend to perform well when inflation is rising, and as economic activity picks up. One reason that stocks are a good hedge is that inflation generally means that the economy is healthy, companies are producing, consumers are making purchases and business employment and wages are strong. Furthermore, corporate revenues and earnings are growing, which provides support for equity prices.

That being said, volatility may pick up over shorter periods as the focus may only be on the reduction of the present value of future earnings, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. Dividend-paying companies that increase their dividend stream on a consistent basis at a rate greater than inflation can provide an additional hedge.

David Sowerby, CFA Managing Director, Portfolio Manager

Q: David, what does the empirical evidence suggest about equities and their inflation-fighting abilities?A: Over a long-term environment of mild 2.5-3.0% inflation rates, U.S. stocks are arguably the best asset to achieve a favorable inflation-adjusted real rate of return. In the current environment, with most investment grade bonds yielding less than 2% and the underlying inflation rate roughly the same, stocks are even more compelling as a favored asset class, relative to bonds, in portfolios for investors seeking a real rate of return.

However, even equities have struggled to generate real rates of return when inflation rates have climbed above 4.5 -5.0%. That was particularly the case from 1965-1982 when the U.S. transitioned from a low inflation and interest rate environment to one of escalating inflation and interest rates. It was only in mid-1982, when investors developed greater conviction regarding the Federal Reserve’s fight on inflation, that stocks resumed their ability to compound at more favorable levels. So, the absolute level of inflation is relevant.

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Today, we are witnessing a period of modestly higher interest rates, in part driven by expectations that inflation rates will incrementally move higher. Currently, there is less evidence of a return to inflation rates over 4.0%, which would prove problematic for longer-term stock returns. Interestingly, as inflation does move marginally higher, and interest rates are already reflecting this, value-leaning stocks have historically participated well in this type of macro environment. This is in large part because value stocks tend to have greater sensitivity to better economic conditions and profit growth.

Dan Thelen, CFA Managing Director, Small/Mid Cap Equities

Q: Dan, how do you think about inflation and the impact on businesses and security selection as a small cap investor?A: Generally, small cap stocks tend to outperform during periods of inflation, principally because inflation can be a symptom of economic growth. More specifically, small cap stocks tend to outperform early in the economic growth cycle because they feel the impact of the renewed growth cycle, in many cases, a little earlier and disproportionately. Most importantly, given there are more than 2,000 companies which can be classified as small cap stocks, there are plenty of opportunities to identify those that will benefit the most from inflation.

The main characteristics of potential winners are companies that possess an intangible asset, e.g., a patent, contract and/or trademark that supports solid pricing power in the event they have to pass along higher input costs, or companies with relatively large inventories that increase in value before being sold. The early signs of some inflation and reemerging economic growth this year have been very positive for small cap stocks. Continued slowly-rising inflation should continue to provide a positive backdrop for small cap stocks.

Michael Santelli, CFA Director, Portfolio Manager

Q: Michael, as a portfolio manager, how do you think about cyclical opportunities versus longer-term secular growth opportunities in a period of potentially rising inflation? A: The Fed is certainly getting more and more serious about getting inflation to at least 2% and even higher. If they are successful, and that’s not a certainty, cyclical companies should do well in the early stages of that environment. We are already seeing commodity prices push higher, in some cases much higher. The producers of those commodities are big beneficiaries, while the users of those commodities will likely experience margin compression.

However, as the inflationary environment continues, quality value-added companies, no matter where they are in the production chain, should be able to pass higher input costs to their customers to maintain margins. In the meantime, commodity cyclicals will likely experience increasing costs at some point in the cycle.

So, as a portfolio manager, the core of the portfolios we build consists of quality companies with strong balance sheets that can weather stormy seas. Cyclical companies, which are generally of lower quality (though not always) are more opportunistic investments, in my view.

Jeff van Fossen, CFA Managing Director, Portfolio Manager

Q: Jeff, overall what is the mindset of successful long-term investors that helps them overcome inflation fears or other periodic “wall of worry” items?A: I like to think in terms of investment principles, and it comes back to keeping our focus on what we have control over as investors. Inflation is a predictable and continual process that impacts all investments to varying degrees, and successful investors carefully plan for this. Clearly, if we hope to achieve long-term financial goals, such as a comfortable retirement or college savings for children,

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we’ll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation, which is something we’re always considering.

Conducting a review of investments that are most likely to provide returns that outpace inflation is something we do regularly on behalf of clients. But the successful investor mindset remains the same: Proper comprehensive planning underpinning an appropriate portfolio asset allocation, diversification, quality security selection, frequent communication paired with investor education (a remarkable antidote to fear), maintaining a long-term investment strategy and perspective and assiduously avoiding market timing and emotional decision-making. ◊

Commodities & Inflation Q&A: What You Need to Know Paul Caruso Director, Commodity Investments

Q: Inflation is a topic that has garnered a lot of attention lately, how might this time be different?A: The biggest difference now versus in the past, is the Federal Reserves’ recent policy change to an average 2% inflation target, from the previous single-point target of 2%. We believe the Fed will keep rates low as in the past, but will now allow inflation to exceed 2% to maintain the longer-term average at 2%. This policy switch is geared towards stoking inflation.

COVID-19 has also impacted all aspects of the global economy unlike past events that were more compartmentalized or regional. For example, the 2008 financial crisis was mainly isolated to housing and banks. That’s not to say its reach didn’t extend beyond those two sectors, but it was nowhere near the extent we saw with COVID-19 in terms of supply chain disruptions, etc. The actions taken by the Fed and the government addressing the 2008 crisis were also more targeted. Conversely, we now have a synchronized global recovery effort taking shape as vaccines become available and governments reignite their economies. Stimulus is widespread and direct to consumers this time as well. This restart is occurring at a time when consumers, especially U.S. consumers, have strong balance sheets and are being directly provided additional funds that will create spending and therefore demand.

Q: What are some leading indicators to follow as it relates to inflation and inflation expectations? A: I pay particular attention to the producer price index (PPI). PPI includes goods and services purchased by other producers as well as goods and services purchased by consumers. A higher-cost incurred from a producer-to-producer transaction doesn’t necessarily get passed through to a consumer, but it is still representative of an imbalance in the supply and demand for said material or good. In other words, inflationary pressures can occur at different points on the supply chain curve. Historically, price movements at the producer level are more correlated with commodity prices, which intuitively makes sense given it is earlier in the supply chain process. Given my focus on commodities, this is the index I follow more closely.

Another macro-economic data point I monitor is monetary policy. In a globalized economy, the monetary policies of other nations provide insights into inflationary concerns across the globe. If other central banks begin to hike rates, it is likely a sign that inflationary pressures are real and, given globalization, the chances that some of those inflationary pressures get imported into the U.S. increases.

Lastly, rates cannot be ignored. If there is one data point that could derail the inflation theme, it is higher rates, especially in the belly of the curve. A sharp move higher in rates could lead to USD strength and keep a ceiling on inflation.

Q: From the point of view of commodities, what is occurring that might ultimately lead to inflationary pressures?A: COVID-19 had a profound effect on commodities. It curtailed supply by shutting-in capacity, it redistributed demand and it shifted capital flows. Think about how consumer trends changed due to COVID-19; spending for leisure and entertainment were redirected towards home improvement, spending for out-of-home food consumption was redirected towards in-home food consumption, spending for business attire was redistributed to casual attire, etc. These events led to reduced inventories and offline capacity as demand channels shifted.

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As we emerge from COVID, it will be about “following the money.” Will consumer habits change course again? Broadly speaking, there will undoubtably be a mismatch in select industries where demand outstrips supply, or a supply response is too slow to absorb rising demand, and this is where inflationary pressures will develop. Supply chains are still constrained, inventory levels are still inadequate and consumer trends are constantly changing.

Q: Where do you see the most opportunities in commodities as it relates to this inflationary theme?A: When I look across the commodity complex, there are two types of situations developing. One in which supplies are already critically low and the other one in which supplies are adequate but the forward outlook indicates those inventories will be drawn down as a rebound in demand outpaces the supply response. The former situation is prevalent in the grains and oilseeds while the latter situation is indicative of energies.

In both cases, we see opportunities in the forward part of the curve. In other words, with respect to the grains and oilseeds, it’s going to require more than one crop year to replenish inventories, so a long exposure to new crop contracts is an attractive risk/reward in our opinion. Similarly, owning crude oil, for August 2021 delivery for example, is attractive because it should capture pent up consumer demand from the reopening of the economy and still be within the period that the supply response will not be able to react quickly enough.

Q: Some firms have mentioned the idea that commodities are entering into a new super-cycle, what is your opinion on this?A: Commodity super-cycles are defined by extended periods during which prices are well above (or below) their long-term trend. Some analysts believe we are entering into an upswing super-cycle. Typically, this occurs when there is abnormally strong demand growth and supply cannot keep pace. In other words, inflationary pressures stem from the pull of demand, rather than supply-side events, which can produce sharp spikes but tend to be more transient in nature. The last major upswing super-cycle occurred because of BRIC nations (Brazil, Russia, India and China) experiencing rapid economic growth.

I am unsure as to whether we are entering into a super-cycle or if this is just a reflation trade, but the key will be to see how supply responds. There is offline capacity, but it remains unclear if it has been permanently shut-in due to COVID-19 and financing issues, or has just been idled. In any case, we do believe there is still upside potential in select commodities as the mismatch between demand and supply will be exacerbated as we emerge from COVID-19. If inflation ends up gripping the real economy, commodities, as indicated below, could be a way to play offense in a portfolio.

Source: State Street Global Advisors; Macrobond, Bloomberg, State Street Global Advisors, as at 31 May 2020. ◊

Inflation Beta and Correlation to Inflation

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