By way of reminder, it’s been nearly 30 years since inflation in the U.S. exceeded 4% and nearly four decades since the country experienced a protracted run of rising prices. A period of the sort is likely to be unremembered, unknown even, for a good number of us.
But as the post-COVID economy picks up steam, many economists predict a jump in the cost of consumer goods and services in the months ahead. While there’s still considerable uncertainty to any prediction you’ll hear in the media — and you’re doubtlessly hearing a few — it seems sensible now to help your clients prepare for inflation.
Monetary balancing act
Economic inflation, by definition, is a steady rise in prices over time. For the consumer, that translates to increased costs for anything from purchasing a house to a haircut, which isn’t, on the whole, a bad thing. Modest price increases are normal and a bit of inflation is actually good for the economy .
Too much inflation, however, can be a bad thing, causing the economy to slow down as businesses become less likely to invest and expand, but a fast-rising run-up can lead to a rise in unemployment as aggregate demand declines and fewer people are employed to provide goods and services. This unpleasant combination of events can cause an economic boom to suddenly turn to bust, as Americans saw in the late '70s. How bad was the period of the so-called Great Inflation? Ask your clients if they remember when home mortgage rates were over 17%, checking deposit rates touched 12% and the jobless rate was nearly 10%.
By all appearances, today’s policymakers agree that something close to the 2% number is the optimal rate of inflation for economic growth. At last report, in September 2021, the U.S. inflation rate was 5.4%. That’s why everybody’s talking about inflation today.
The consumer is coming back
It’s not too much of a stretch to think that this pick-up in inflation was inevitable. It’s reasonable to think folks will get back to at least some of their old spending habits as the economy opens up and as supply chains improve.
At the same time, the pent-up demand in the global economy for just about everything is contributing to an unusual imbalance in the supply chain. As the economy adjusts to a post-pandemic world, key materials such as computer chips, steel, chlorine and lumber are in short supply as suppliers cope with reduced capacity and an overwhelming surge in demand.
It’s reasonable to expect that suppliers will adjust and these shortages up and down the economic landscape will dissipate. The question facing the economy is how long it will take.
I’ll not wager on the duration, but I will suggest there’s enough in the way of unknown outcomes for advisors to re-visit their investment planning assumptions.
Opportunity for good advice
The good news is that the stock market — despite all the chatter — has been moving higher since the second quarter of 2020. Price on the 30-year Treasury, meanwhile, has moved slightly lower across the last 12 months. This relative stability might provide a window of opportunity for savvy financial professionals to position their clients for an extended period of inflation.
Specifically, I think clients in this environment would benefit from a deep dive into the private real estate market. Given its historical risk-adjusted return profile, private real estate can be utilized as an enhanced allocation or as an alternative to traditional corporate bonds or U.S. Treasuries.
Historically, private real estate has performed fairly well in an inflationary environment. Why? Because not only is the value of the property likely to rise with inflation, the amount that tenants pay in rent will likely increase as well.
Leases in the commercial space typically have 2% to 3% contractual rent increases built in, so over time, market rent would go up, even in an inflationary period. And then a lease expires, rent can be raised to current market conditions. Smart real estate operators also like to stagger lease terms so different leases are rolling off every calendar year. Meanwhile, valuations are likely to go up as property income increases and the underlying real estate increases in value.
Whatever the environment, private real estate holds intrinsic value because it is scarce. It is, after all, a tangible asset. Limited supply is good news for property owners as demand for real estate does not generally decrease, no matter the economic environment. In fact, the value of an existing property might increase in an inflationary period, given the replacement cost of materials and labor required to build new properties.
We all have our opinions, of course, but at this hour there exists little in the way of consensus regarding inflation in the U.S. and its future path over the next few years. In this environment, constructing a diversified investment portfolio to help hedge against multiple inflation or interest rate volatility scenarios would make sense. In my view, financial professionals and investors with allocations toward private real estate will be well-positioned if higher inflation persists. Better yet, they will own an attractive asset if it doesn’t.
