Iron Capital Insights

  • Iron Capital Insights
  • September 29, 2021
  • Chuck Osborne

The Real Risk

We have been saying for a while now that the market is in need of a correction. No one likes corrections, and many investors are downright afraid of them. Any sign of downward price movement in their portfolio sends them seeking shelter. This is understandable; no one likes seeing the value of what they own going down, even if deep down they know it is temporary.

This is the market risk that many investors just do not want to experience. However, there is another risk which is less obvious but far more serious: failing to grow your money at the rate of inflation. In the last year the fearful investor who put his money into a safe cash-like investment would have been fortunate to receive a 2 percent return. The rate of inflation through August was 5.3 percent. This investor lost more than 3 percent of his purchasing power and in all likelihood doesn’t even realize it. If one were to continue that strategy, he would very likely end up outliving his money.

This has not really been a concern for a long time as inflation had been tamed; however, with the return to economic thinking that led to runaway inflation in the 1970’s, we are once again seeing a return to inflation coupled with lower economic growth. The Atlanta office of the Federal Reserve has a GDP forecast based solely on quantitative inputs, or in other words it is not adjusted up or down based on any human judgement, it is just the facts. At the end of July, this tool projected GDP growth of 6.1 percent; as of September 27, this tool is projecting GDP growth of just 3.2 percent. This is an enormous drop in GDP expectations in a very short time, and it follows actual GDP missing expectations by 2 full percentage points.

©taikrixel

If the rate of growth in economic activity is dropping like a stone, then how can it be that inflation is so high? I’m sure you have heard by now, but the global supply chain is a total mess. According to research by JP Morgan, there are more than 70 container ships in a queue outside Los Angeles. That is a record. So, what is causing the backup? It is the combination of spiking demand and a lack of workers.

One can pass the buck to Covid if she wishes, but the truth is, this is the result of policy decisions. Sure, the pandemic may shut down production in certain areas due to outbreaks, but that would ordinarily reduce demand right along with the reduction of supply. However, policy during the pandemic did not just make people whole, replacing their wages mostly or even dollar-for-dollar, which would ease suffering. No, policymakers decided people need to make more money when quarantined than they would in real life. What did people do? They spent it on stuff, lots and lots of stuff. They might have spent it on eating out or going on vacations, but they were not allowed. Stuff is what they could spend it on, so stuff is what they bought. A large quantity of this stuff is now sitting in ships anchored outside of ports, waiting for the people who bought the stuff to actually come back to work and unload it.

©Yingko

Meanwhile, the experts at the Fed have been telling us that the spike in inflation is “transitory” (which I thought meant temporary or fleeting, but evidently they have a different definition). It is true that the latest inflation reading was 5.3 percent and that was down from 5.4 percent; however, JP Morgan points out that this decrease was mostly from declines in airfare, lodging and rental cars, which can be attributed to the Delta variant. This will likely bounce back, and other categories are still rising sharply.

It appears that people are waking up to this. In the last week or so the interest rate on the 10-year Treasury has risen from the 1.3 percent range to more than 1.5 percent. That may not sound like much to a lay person, but this is a sharp rise in a short period of time. However, even with a 1.5 percent yield, that means a loss in purchasing power of 3.5 percent per year when compared to inflation being more than 5 percent.

In my opinion, inflation is the real risk in the market, not volatility. We are likely due for a correction, but we would see that as a buying opportunity. Stocks are the best long-term hedge against inflation. If the volatility causes investors to run to what they believe are safe havens, then those investors are likely to experience real loss as the cost of living grows faster than their money. In investing, as in life, what people fear and what they should fear are often very different. Don’t fear the sudden drop of a market correction; fear the slow bleeding of inflation outpacing your savings.

Warm regards,

Chuck Osborne, CFA
Managing Director