What Investors Should Know About Investing During Rising Inflation

Increasing inflation fears remain the primary concern weighing on financial markets. The U.S. economy is still digesting the pandemic-induced inflation spike while concerns over the new administration’s fiscal policies and potential increases in government debt are stoking new inflation fears and driving market volatility.

Investing during periods of high inflation is difficult. Successful investors need to pay attention to the most recent economic data, the drivers of current inflation and what markets are saying. From that, investors can derive an investment strategy tailored to the current situation—because similar inflationary periods from the past may not have produced the same outcomes.

#1: Which Economic Releases Should Investors Pay Attention To?

There are two types of inflation measures that investors should pay attention to: backward-looking and forward-looking data points.

Backward-looking data includes the Consumer Price Index, Producer Price Index and Personal Consumption Expenditure. These indexes look at the different measures of inflation over various prior time periods and are used to adjust Social Security payments, Treasury inflation-protected securities bond cash flows and other investments and payments where the actual inflation data is required.

Forward-looking data includes inflation surveys, such as the University of Michigan Inflation Expectations and the Conference Board Consumer Confidence Inflation Expectations, as well as market-derived data, such as 5-year TIPS inflation expectations and the 5-year, 5-year forward inflation expectations. (Both of the latter are market-based forecasts of what investors expect inflation to average over the next five-year period.)

Which Is More Important: Forward-Looking Or Backward-Looking Inflation Data?

Backward-looking data is important in assessing whether inflation is growing or declining at targeted levels. The Federal Reserve has consistently identified a 2% long-term target for inflation as the appropriate rate to accomplish their inflation mandate. The data also helps to identify specific areas that are contributing to higher or lower inflation to determine if such variables are persistent or temporary disruptions. This helps in determining the appropriate fiscal and monetary policy.

In our opinion, forward-looking data is just as important as, if not more important than, backward-looking data during some time periods. Whether it’s consumer- or industry-based surveys or market-derived expectations, this data helps policymakers anticipate near-term economic behaviors such as consumption, job creation, purchasing plans and other key factors.

The market-derived, forward-looking data helps to determine what is already priced into various investments and markets. Specifically during periods of transition, such as the current environment with the change in the executive branch and the recent adjustment in monetary policy, a view to expectations is important. The Fed has highlighted both inflation and inflation expectations as key inputs to any change in monetary policy.

#2: What Does The Inflation Data Show?

The various measures of actual inflation show a high inflation rate that is above the Fed’s long-term target of 2%. The CPI and PCE data, both core and non-core components, show the year-over-year inflation running between 2.79% and 3.50%. While this is concerning, the overall trend is lower than the highs experienced during the post-pandemic supply chain disruption. While the Covid-19 crisis is mostly behind us, the underlying data indicates that the largest increase to core inflation over the last year has come from increases in housing and medical care costs. Conversely, durable goods and core goods have contributed to small declines.

The source of recent inflation is important—the lack of housing and higher mortgage rates have been contributors to increasing shelter costs. Freddie Mac estimates that there is a shortage of 3.7 million units in the U.S. Houses can’t be built overnight, which means housing inflation will remain an issue for some time.

Elevated mortgage rates have also added to the problem. The Bankrate.com 30-year average mortgage rate as of February 25 was 6.93%. Despite the lowering of front-end rates by the Federal Reserve, mortgage rates remain stubbornly high—something I cautioned when the Fed started cutting rates in the fall.

The decline in durable goods and core goods costs is positive, however, the potential for an increase in goods prices due to higher tariffs could add to near-term goods inflation.

#3: What Are Markets Making Of Inflation?

While the backward-looking data is still showing uncomfortable levels of inflation and the forward-looking survey data also suggests that inflation will remain high, the data derived from the financial markets is showing that a modest level of inflation expectation is already priced in.

Both the Conference Board and University of Michigan surveys show that participants are expecting higher inflation, the highest levels in over a year, but the market data shows that inflation is already priced into financial markets. Specifically, the five-year TIPS market is pricing in 2.6% inflation on average over the next five years, which is the highest since the fourth quarter of 2022. Additionally, the Fed’s 5-year, 5-year forward inflation expectation rate is pricing in 2.4%, which is higher than the average over the last two years.

It’s important for investors to understand what is already priced into markets. For example, an investment that is expected to do well during periods of high inflation could underperform if the investor does not realize what is already embedded in the current market price.

The Best And Worst Performers During Periods Of High Inflation

Investing successfully in periods of high inflation can be difficult. Simply going back, looking at a time period when inflation was high, reviewing performance and mirroring investments in those best-performing assets may not be the right answer. Investors should understand the source of the inflation, what was priced in and what is different this time.

Using the 1970s as an example, the causes of inflation were higher energy prices, rising unemployment and poor monetary and fiscal policies, which created stagflation. During this period, commodities, precious metals, energy stocks and real estate did well. Treasury bonds underperformed inflation along with domestic equity markets.

A similar shock to oil prices occurred in the late 1980s and early 1990s. However this time, equity indexes and Treasury bonds were top performers, while gold underperformed.

Most recently during the post-pandemic supply chain disruption, bonds were the worst performer, followed by gold and equities, while oil did well.

Of the sectors mentioned above and shown below, real estate and oil were the only consistent best performers. However, that is misleading because for two of the three periods mentioned, spiking oil prices were the source of inflation.

The Bottom Line: Each Period Of Inflation Is Different. Investors Must Do Their Homework.

The data conclusion suggests that each inflationary period is different, therefore, investors looking to the past for guidance into the future may be disappointed. It’s important to understand the source of the expected inflation, an estimate of the potential inflation and how much inflation is already priced into the market.

Should inflation continue to cause volatility in markets, there will be specific companies and sectors that outperform others. During such times, successful investing can be difficult for individual investors, but for those willing to do their homework, an active management approach can yield rewards. For those less hands-on, seeking the advice of a seasoned professional may be beneficial. Uncertainty drives volatility, and volatility creates opportunities. If nimble and flexible enough, investors can seize opportunities for potential gains.