Abacus Investment Committee Insights: Setting Inflation Expectations

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Inflation in 2021 clocked an eye-popping 7.0%, the highest rate in 40 years. Over those 40 years, inflation averaged just 2.8% and has been trending lower every decade, averaging 2.25% over the last 30 years, 2.04% over the last 20 years, and 1.74% over the last 10 years. So, this spike is quite notable. 

Briefly, inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in the economy. It occurs when the demand for goods and services exceeds the supply of goods and services.

Why should you care? If you had $100,000 in your bank account on January 1st, earning 1% interest, the nominal value of your account grew to $101,000 by December 31st — but it’s real purchasing power fell to $94,392. 

If recent polling is to be believed, Americans are more concerned about inflation than the COVID-19 pandemic. That is remarkable.

Is Inflation Here to Stay?

The question on everyone’s mind is whether 2021 is a temporary blip that will recede into the mists of history or a persistent economic headwind. The click-baiting financial media who derive income from eyeballs is more than happy to splash worrisome headlines across our smart phone screens. 

Abacus, on the other hand, gets paid by you to soberly assess risks, provide perspective, and generally position your finances in an unassailable position that inoculates you from worrying about whether you can achieve your financial objectives.

Where then does the Abacus Investment Committee look to weigh the risk of persistently elevated inflation? We look to markets. Markets are not perfect. As the old saying goes, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” It is our bedrock belief that while markets can be fallible, individual, or organizational judgment is far more fallible. We believe in the relative wisdom of crowds, and the data supports that belief.

Understanding the Role of Bonds

How, precisely, does one look to markets to gauge its expectation for inflation? Quite simply, you take the yield of a traditional U.S. government bond and subtract from it the yield of an inflation protected U.S. government bond. 

A traditional bond’s yield reflects the collective judgment of all investors buying and selling trillions of dollars of existing and newly issued U.S. government bonds (some being short-term 3 month notes and others long-term 30-year bonds). Those investors are highly motivated to avoid a decrease in their long-term purchasing power. And they seek a yield commensurate with maintaining (or increasing) their purchasing power.

An inflation protected bond pays a lower yield than a traditional bond. In fact, going into 2021, those yields were negative. You read that right. Investors were willingly buying a financial instrument that, in the absence of inflation, would lose value. Why? Because inflation protected bonds adjust their price such that investors receive an increase in value equal to actual inflation.

Investors have the option to buy either the traditional or inflation protected bond. Given that trillions of dollars are flowing into and out of these financial instruments, there is a vast army of analysts with sophisticated models running on supercomputers determining where the advantage might lie. The net effect is that either bond is expected to have the same outcome over time. And thus, subtracting one from the other reveals the consensus of all bond investor’s expectations for inflation.

Investors, Consumers and Recency Bias

Investors expect inflation, over the next 30 years, to average 2.25%, exactly the average that we have experienced over the prior 30 years. Perhaps more notably, the expectation is for inflation to run at 3.7% over the next year. That is nearly half as much as we saw in 2021.

EXIBIT 1 [1] [2] [3]

Investor Inflation Expectations 

Inflation Expectations

To most readers, that simply will not feel right. And you are not alone. Consumers, as opposed to investors, expect inflation to run much higher. The Federal Reserve regularly conducts a survey of American consumers to gauge their inflation expectations. After experiencing decades of low inflation, consumers came to expect low inflation. 

That changed when we experienced the recent pandemic-induced bout of inflation. Consumers radically changed their outlook. In the chart below, we can see the results of the December Fed survey. Consumers expect prices to rise 6% in the next year and 4% on average over the next three, a marked jump in expectations in just the last year. Incidentally, this is a textbook example of recency bias. Recency bias is a cognitive bias that favors recent events over historic ones. Abacus advisors are warriors against recency bias.

EXHIBIT 2 [4]

Median Expected Inflation Rates

graph of median expected inflation rates over time

Looking to the Future

Expectations are not destiny, be they the expectations of investors directing trillions of dollars annually or consumers purchasing necessities daily. When future information comes to light, it will change expectations. Sadly, future information is unknowable. Our crystal ball is still out for repair. Therefore, prudence demands that we hedge against possible (as well as probable) risk. Equities have been a historically reliable hedge against inflation. Real estate, which is also in your portfolio, is as well. Gold, as this column examined in July of 2021, is not. Bitcoin is not.

That is why even clients deep into their retirement will have stocks and real estate in their portfolios. Each client’s financial circumstances are unique. But a 60% allocation to stocks and real estate is common for our clients who are entering retirement. And rarely will that allocation drop below 40% to 50% deep into retirement. Ultimately, by remaining grounded in historical data and avoiding “crystal ball” prognostications, we can help weather whatever markets and the economy throw our way.


References: 

[1] “Bonds & Rates: U.S. Treasurys 30-Year Bond” Wall Street Journal 

[2] “Treasury Inflation-Protected Securities” Wall Street Journal 

[3] “Daily Treasury Par Real Yield Curve Rates” U.S. Department of the Treasury

[4] “Survey of Consumer Expectations” Federal Reserve Bank of New York

Disclosure: 

Abacus Wealth Partners, LLC (Abacus)is an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”), with its principal place of business in the State of California. Registration as an investment adviser does not constitute an endorsement of the firm by the SEC, nor does it indicate a particular level of skill, training, or ability.

Nothing herein should be construed as a solicitation, recommendation, or an offer to buy, sell, or hold any securities or other investments or to adopt any investment strategy or strategies. The article is for educational purposes only; and contains the opinions of the author, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances.

More Information about Abacus’ advisory services and fees can be found in its Form ADV 2A and Client Relationship Summary (“Form CRS”), which are available free of charge and upon request. Past performance is not indicative of future results. Readers of this information should consult their own financial advisor, lawyer, accountant, or other advisor before making any financial decisions.

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