Elevated Inflation – Transitory or Taken Root?

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Background

Inflation has surged in 2021, with the consumer price index (CPI) hitting a recent high of 5.4% year-over-year and the less volatile Core CPI, which excludes food and energy, reaching 4.5%. These were the largest gains for the two indices since 2008 and 1991, respectively. The Federal Reserve, responsible for promoting stable prices as half of its dual mandate, has consistently described this inflation as caused by transitory factors that will quickly fade. This is a sentiment echoed by many other analysts, who point to pandemic-induced supply chain snarls and the rapid recovery of consumer demand as temporary drivers causing most of the increase. However, with “transitory” inflation already proving more persistent than initially expected and forecasts calling for it to last at least into 2022, there are growing doubts about this narrative.

What Factors are Considered Transitory?

This discussion requires recognition that some components of inflation naturally fluctuate more frequently than others. In fact, this is the primary reason “Core” CPI exists in the first place – food and energy are typically two of the more volatile components, making inflation changes based on these prices a poor guide for monetary policy.

However even within Core CPI, there is a broad range of price sensitivity. An analysis performed by the Federal Reserve in 2010 identified “flexible” components, in which prices change every four months or less, versus more static or “sticky” components of the CPI market basket. Flexible price items (outside of food and energy) consist mostly of automobiles, apparel, and lodging away from home. Sticky prices are typically less responsive to current economic conditions and includes a number of service categories, including food away from home, medical services, and housing categories. This analysis found that approximately 18% of the Core CPI market basket were flexible price items.

Reading Today’s Tea Leaves

The impact of flexible-price items on current inflation has been substantial. When Core CPI peaked in June, used vehicles, at a little over 4% of the index, accounted for over 40% of the monthly increase while used vehicle prices soared 45.2% year-over-year. This was directly attributable to a surge in consumer demand for vehicles combined with a semiconductor shortage slowing new vehicle production, both of which are expected to be temporary. While other examples are less extreme, firm price increases have been seen more broadly, with unusual demand or supply disruptions repeatedly blamed as the culprit. The transitory narrative still makes logical sense, but as ships continue to pile up in ports these price increases are proving to be longer lasting and current inflation dynamics are now expected to persist into 2022. For now, sticky-price inflation still remains within a “normal” range relative to the last 25 years, and structural forces underpinning recent history’s low inflation environment should regain ground as pandemic effects fade.

Our Position

Inflation predictions today are as challenging as ever, but current risks do appear skewed to the upside. Inflation specific hedges are available, but such tactical adjustments can prove costly (and not always effective). Furthermore, a diversified portfolio across equity, fixed income, and real assets is already well positioned to withstand various environments. Both equity and real assets have historically provided positive real returns in high inflation periods. Core fixed income tends to be a less effective inflation hedge, with returns primarily driven by the interest rate environment. The two are linked since lenders demand a higher yield when inflation ticks up – but a number of other factors influence rates as well, leading to mixed results depending upon the inflationary environment. At the strategy level, opportunities for further hedging exists via active managers who seek to mitigate the adverse impacts of inflation through tactical sector and/or security selections.

Disclosures

The views expressed herein are those of Asset Consulting Group (ACG). They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm.

This report was prepared by ACG for you at your request. Although the information presented herein has been obtained from and is based upon sources ACG believes to be reliable, no representation or warranty, express or implied, is made as to the accuracy or completeness of that information. Accordingly, ACG does not itself endorse or guarantee, and does not itself assume liability whatsoever for, the accuracy or reliability of any third party data or the financial information contained herein.

Certain information herein constitutes forward-looking statements, which can be identified by the use of terms such as “may”, “will”, “expect”, “anticipate”, “project”, “estimate”, or any variations thereof. As a result of various uncertainties and actual events, including those discussed herein, actual results or performance of a particular investment strategy may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making investment decisions. ACG has no duty to update or amend such forward-looking statements.

The information presented herein is for informational purposes only and is not intended as an offer to sell or the solicitation of an offer to purchase a security.

Please be aware that there are inherent limitations to all financial models, including Monte Carlo Simulations. Monte Carlo Simulations are a tool used to analyze a range of possible outcomes and assist in making educated asset allocation decisions. Monte Carlo Simulations cannot predict the future or eliminate investment risk. The output of the Monte Carlo Simulation is based on ACG’s capital market assumptions that are derived from proprietary models based upon well-recognized financial principles and reasonable estimates about relevant future market conditions. Capital market assumptions based on other models or different estimates may yield different results. ACG expressly disclaims any responsibility for (i) the accuracy of the simulated probability distributions or the assumptions used in deriving the probability distributions, (ii) any errors or omissions in computing or disseminating the probability distributions and (iii) and any reliance on or uses to which the probability distributions are put.

The projections or other information generated by ACG regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Judgments and approximations are a necessary and integral part of constructing projected returns. Any estimate of what could have been an investment strategy’s performance is likely to differ from what the strategy would actually have yielded had it been in existence during the relevant period. The source and use of data and the arithmetic operations used for calculating projected returns may be incorrect, inappropriate, flawed or otherwise deficient.

Past performance is not indicative of future results. Given the inherent volatility of the securities markets, you should not assume that your investments will experience returns comparable to those shown in the analysis contained in this report. For example, market and economic conditions may change in the future producing materially different results than those shown included in the analysis contained in this report. Any comparison to an index is for comparative purposes only. An investment cannot be made directly into an index. Indices are unmanaged and do not reflect the deduction of advisory fees.

This report is distributed with the understanding that it is not rendering accounting, legal or tax advice. Please consult your legal or tax advisor concerning such matters. No assurance can be given that the investment objectives described herein will be achieved and investment results may vary substantially on a quarterly, annual or other periodic basis. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.

Gryphon Financial Partners shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This was created for informational purposes only. Gryphon Financial Partners, LLC is an Investment Adviser.

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