New inflation fears rattle Wall Street, retirement planners

Fears of tax increases have yielded, for the moment, to mounting concern about inflation.

Wealth managers and their clients are now enduring a second straight week of whipsawing uncertainty over how much their taxes might go up — or, in some cases, potentially stay put — under a trillion dollar plan put forth by Democrats. With many of the proposed increases now subject to an epic fight among legislators who want to curtail or perhaps kill some of them, inflation has emerged as the new spoiler for retirement.

“The sheer magnitude of the numbers is causing a shift in perceptions,” said Dan Suzuki, the deputy chief investment officer at Richard Bernstein Advisors, a $15 billion wealth management firm in New York. “Now the market’s starting to wake up.”

Bloomberg News

Consumer prices spiked 5.4% in the 12 months through last September, the highest rate in 13 years, according to the Bureau of Labor Statistics. That’s the same rate as in June and July, when the pandemic economy first reopened, and a notch above August’s level. The rate is more than double the Federal Reserve’s 2% annual target, and it comes as the COVID economy struggles to recombobulate.

Wall Street, in a light-bulb-goes-on moment, is suddenly more worried than ever.

The latest Bank of America survey of fund managers, published Oct. 19, showed nearly one in four investor clients betting that inflation is here to stay and not a temporary blip as the economy reboots itself. The Wall Street bank found money managers the least bullish since October 2020, with their allocations to bonds — which typically suffer in inflationary periods — at an all-time low and cash reserves at a 12-month high. More advisors viewed the current run up in prices as permanent, 38% this month, compared to 28% in September.

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“We are clearly in a weakening growth/high inflation era that appears less 'transitory' every day,” Liz Ann Sonders, a managing director and chief investment strategist at Schwab, wrote in a research note earlier this month.

The pessimism is trickling down to individual advisors. The latest Retirement Advisor Confidence Index, or RACI, Financial Planning's monthly barometer of business conditions for wealth managers, found that a growing number of investors were becoming more risk-averse as they increasingly questioned whether inflation could drive the stock market down.

The hidden tax
An unusual constellation of factors is pushing prices up.

First, there’s the spending spree by pandemic-weary consumers who are flush with cash from stock market gains and trillions of dollars in federal pandemic relief that have flowed to individuals and businesses. Too many dollars are chasing too few goods, with supply chain bottlenecks growing as companies re-ramp up production and imports and struggle to find workers as employees quit their jobs in record numbers. Nearly 734,000 pandemic deaths so far have also reduced the labor pool. Higher prices are everywhere — for groceries, gasoline, rents, raw materials and imported semiconductors, a critical component of cars and electronic devices. While wages are also up, that doesn’t mean consumers can buy more stuff.

That’s because inflation is like a hidden tax — both decrease the actual amount of money an investor has to spend or invest. Still, it’s been almost two generations since investors thought about inflation, which last reared its head in force in the 1970s.

“Of all the fears investors have faced over the past 30 years, high inflation wasn’t among them. In 2021, that’s changed,” Pramod Atluri, a portfolio manager at Capital Group, a $2.6 trillion investment manager in Los Angeles that’s home to American Funds, wrote on Oct. 14. “Today, the biggest questions for investors revolve around inflation: How high will it go, and how long will it last?”

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In the 1970s, higher incomes pushed taxpayers into higher tax brackets, even as they had less purchasing power, leading in the 1980s to the introduction of “inflation indexing,” or cost-of-living adjustments. But not all tax provisions are tied to inflation — for example, the $3,000 annual limit on deducting capital losses stems from 1978, an amount that under inflation should now be around $13,000. One worry this time around is that persistent inflation will prompt the Fed to raise its rock-bottom interest rates sooner rather than later, a hike that could crimp retirement portfolios by making mortgages and consumer loans more costly and existing bonds worth less.

Not just Wall Street is concerned. Federal Reserve officials wrote in their September meeting of “a risk that longer-run inflation expectations would move appreciably higher and lead to persistently elevated inflation.” On Oct. 13, the government awarded Social Security recipients a 5.9% increase come next year, the highest cost-of-living boost in 39 years.

Only three months ago, Michelle Meyer, the head of U.S. economics at Bank of America Global Research, said that “thus far, most of the evidence suggests the inflation spike we’re seeing is temporary.”

Three months later, relatively few advisors appear to still be in that camp. “I’m sort of shrugging my shoulders at inflation reports now,” said Preston Forman, a senior partner and CFP at Seasons of Advice Wealth Management in New York. “Certainly, the numbers are concerning, but given how gummed up the world’s supply chain is, it should not come as any surprise that prices are rising.”

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The inflation scare comes as Democrats ponder alternatives to some of their proposed rate increases following opposition from Arizona Sen. Kyrsten Sinema, a crucial vote if any tax proposal is to pass. Two options being considered, according to Bloomberg News, are a billionaires’ wealth tax on unrealized gains and a levy on stock buybacks as alternatives to rate increases.

What is to be done?
Mike Kazakewich, the director of planning for Coastal Bridge Advisors in Westport, Connecticut, said that it was still an open question how long consumer prices would continue to rise. As such, he said, “we have our clients positioned in investments that typically do well in inflationary times such as commodities, real estate investment trusts, growth equities and a focus on dividend equities.“

Suzuki said that 60/40 investors who put the bulk of their portfolios in equities and the rest in fixed income should go “meaningfully less than 40%” in bonds, with a focus on those with shorter maturity dates. “10% underweight makes sense,” he said. He added that investors should also have more exposure to companies that benefit from higher prices, like those in commodities, energies and materials. He likes 2% of a portfolio in gold, a traditional inflation hedge.

Chuck Zuzak, the director of financial planning at independent advisory firm JFS Wealth Advisors in Pittsburgh, cautioned against holding too much cash. “Real returns on cash are very negative,” he said, adding that "the best hedge to inflation in the long run is to hold equity investments in the portfolio.” He cited data showing that returns on stocks had exceeded inflation by 7.3% since 1926.

After years of strong stock market gains by technology companies, investors might have to get used to those other assets. “Forget the pandemic,” Suzuki said. “Even when some of these pandemic pressures ease and ports are more open, there’s still structural tightness in the economy” due to labor shortages. “There’s still more to go — inflation is likely to be higher and more persistent than we expected.”