Did You Know?
The Bureau of Labor Statistics’ (BLS) release of May 2021 inflation data captured the attention of journalists and investors alike.1 CPI-U, or the Consumer Price Index for All Urban Consumers, was up 5% year-over-year. Against a backdrop of considerable government spending and prolonged easy monetary policy, stocks pulled back, yield curves shifted and overall anxiety seemed to increase.2
In this article, we attempt to put the most recent CPI numbers into context as investors contemplate what, if any, prudent action they should take in their portfolios.
It’s worth pointing out that after some small spikes in anxiety, the market has calmed down. As illustrated in Figure 1, the VIX index that measures the cost of protection from a market downturn has continued its downward trend from its March 2020 highs.
Data from 12/7/2017 - 6/7/2021. Source: Bloomberg. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
The VIX Index is a widely recognized measure of volatility. It is designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market. It is calculated using real-time, mid-quote prices of S&P 500® Index call and put options.
Economist Milton Friedman was quoted as saying “inflation is taxation without legislation.” Thinking of inflation as a tax is useful because the reality is that inflation erodes your purchasing power. Said differently, $1 was able to buy more things in 1947 than it can buy today. Figure 2 shows how the purchasing power of $1 in 1947—the longest history available at the BLS website—has declined through time. Today, that same dollar buys about 8 cents’ worth of goods.
Data from 1/15/1947 – 5/15/2021. Source: Bureau of Labor Statistics, Avantis Investors.
If real-life examples are more your style, last year folks at The Daily Meal website gathered examples of food that a dollar could get you from 1937 through 2000.3 Condiment fans might be happy to learn that $1 in 1947 went a long way. The average price for a bottle of Heinz ketchup was about 24 cents, meaning you could take home four of them, significantly more ketchup than that dollar gets you today.
While food is only one component of CPI-U, the fact remains that if we had a bunch of cash in 1947 and stuck it under a mattress, it wouldn’t go as far today. That’s inflation in a nutshell. This is where interest-bearing securities and other investments come into play as investors navigate the tradeoffs involved with preserving (and potentially increasing) their future purchasing power.
In Figure 3, we plot how the purchasing power of $1 invested in Treasury bills, commercial paper and the U.S. stock market has evolved since 1947 relative to keeping it in cash. The results show that even one- month T-bills have done a good job at preserving purchasing power. If we had invested the dollar in the stock market, it would have gained significant purchasing power since the market outperformed T-bills over this period. This is good news for investors, as it demonstrates they have various choices available to help protect against inflation over the long term.
Data from 1/15/1947 – 5/15/2021. Source: Bureau of Labor Statistics, Morningstar, Ken French Data Library, and Avantis Investors. U.S. Stock Market represented by VIX Index Level ($).
The 5% annual increase in CPI seems like a big number when taken at face value. While certainly not small, we can observe where it falls relative to history in Figure 4, where the dotted line plots the 12-month percentage change.
If we think back to 12 months ago, the backdrop was very different from today. In the U.S., we were in the middle of pandemic-related lockdowns, high levels of unemployment and overall slow economic activity. Since then, we have seen tremendous economic growth and significant decreases in unemployment. Pent-up demand for goods and services has strained supply chains and triggered this higher-than-expected “transitory” inflation that many economists expect to be brief.
If we expand our lens from 12 months to 24 months, annualized inflation over the last two years was just over 2.5%. The higher-than-expected 5% inflation was preceded by a period of no inflation, so the inflation environment over the last two years is well within the expected long-term annual range.
Data from 1/15/1949 – 5/15/2021. Source: Bureau of Labor Statistics, Avantis Investors.
Another data set we can observe to compare short-term and long-term inflation expectations are breakeven yields, measuring the difference between similar maturity nominal and inflation-protected Treasuries. Figure 5 shows that the inflation expectations inferred from the breakeven rates, in particular the longer term, are still within expectations.
The breakeven inflation rate is the difference between the nominal yield (usually the market yield, which includes an inflation premium) on a fixed-income investment and the real yield (with no inflation premium) on an inflation-linked investment of similar maturity and credit quality.
Data as of 6/29/2021. Source: Bloomberg.
While we can see that many instruments have preserved or increased purchasing power over time and that a prolonged spike in inflation isn’t certain, investors may still be curious about the potential impact of higher inflation on stock returns. We ran a simple experiment to see if last year’s inflation data has any information about this year’s stock returns.
In Figure 6, the level of inflation is plotted on the horizontal axis of each panel, with inflation increasing from left to right. Panel A shows inflation versus the overall U.S. stock market return, while Panel B compares inflation to U.S. small-cap value stocks. In both cases, it’s difficult to discern any pattern in the data, meaning the relation is pretty weak. For example, in Panel A we can observe several years where inflation was a little more than 4%, but in the years following stock market returns ranged from -37% on the low end to more than 30% on the high end—a range of almost 70%.
Data for both charts from 1/1948 – 12/2020. Source: Bureau of Labor Statistics, Avantis Investors. U.S. stock market is represented by the CRSP Total Market Index and small value stocks are represented by the Small Value Portfolio from Ken French’s Data Library.
Another way to think about this is that if you were trying to use this year’s inflation level to predict next year’s stock market return, you’d probably be relying on luck more than anything else.
So, what’s the main takeaway for investors? Inflation has an adverse effect on our purchasing power, and we can’t stick cash under our mattresses and hope for the best. But in the context of a well-thought-out financial plan, there is probably less to be worried about. As we saw in our earlier example, plenty of investment tools can help preserve and even increase purchasing power across different inflation environments.
In our view, finding an asset allocation you can stick with, embracing diversification and using investment strategies that are tax- and cost-efficient is a sensible way to help stack the odds in your favor toward achieving a positive long-term investment experience.
Call and Put Options. Put-call parity is a principle that defines the relationship between the price of European put and call options of the same class, that is, with the same underlying asset, strike price, and expiration date.
Commercial Paper. Represented by 3-month non-financial commercial paper, which is short-term debt issued by non-financial corporations to raise cash and to cover current expenses in anticipationof future revenues.
Consumer Price Index (CPI). CPI is the most commonly used statistic to measure inflation in the U.S. economy. Sometimes referred to as headline CPI, it reflects price changes from the consumer's perspective. It's a U.S. government (Bureau of Labor Statistics) index derived from detailed consumer spending information. Changes in CPI measure price changes in a market basket of consumer goods and services such as gas, food, clothing, and cars. Core CPI excludes food and energy prices, which tend to be volatile.
CRSP Total Market Index. Comprised of 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market.
Option-Adjusted Spread (OAS). Measures the difference between the yield of a bond with an embedded option and the yield on Treasuries. Call options give the issuer the right to redeem the bond prior to maturity at a preset price, and put options allow the holder to sell the bond back to the company on certain dates. The OAS adjusts the spread to account for these potential changing cash flows.
Small Value Portfolio. The small value portfolio is constructed of small cap stocks with high book-to-market equity ratios, reconstituted once per year in June.
Yield Curve. A line graph showing the yields of fixed income securities from a single sector (such as Treasuries or municipals), but from a range of different maturities (typically three months to 30 years), at a single point in time (often at month-, quarter- or year-end). Maturities are plotted on the x-axis of the graph, and yields are plotted on the y-axis. The resulting line is a key bond market benchmark and a leading economic indicator.
1“Consumer Price Index – May 2021,” Bureau of Labor Statistics News Release, June 10, 2021.
2 To read more about managing inflation expectations in the context of a financial plan, please see Andrew Karolyi, “Managing Great (Inflationary) Expectations,” Avantis Investors, June 2020, https://www.avantisinvestors.com/content/avantis/en/insights/managing-great-inflationary-expectations.html
3 Dan Myers and Jordi Lippe-McGraw, “What Food a Dollar Could Buy the Year You Were Born,” The Daily Meal, April 14, 2020.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.