Inflation: What If It Doesn’t?

For more information on inflation, see Inflation, Money and Debt Puzzle by Thomas S. Coleman, Bryan J. Oliver, and Laurence B. Siegel of the CFA Institute Research Foundation.

As most of us in the West will be taking some time off at the end of the year, I want to invite you to think about your investments and what the coming year and beyond will bring. In particular, I want you to consider all the ways you can go wrong.

For the past few weeks and into early January, I’m going through this process professionally as I write my big annual outlook for 2022. And one of the issues I’m dealing with is inflation. I remain in the camp of those who believe that current inflation, energy price inflation in particular, will be transitory and will subside once energy demand falls in the spring. I’m not as bullish on inflation as the US Federal Reserve: I expect it to be higher than the Fed forecasts, but I still think inflation will ease next year and beyond.

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But what if not?

One thing I have to do is think about what happens if inflation is not transitory. What if energy shortages and supply chain disruptions persist through 2022? What if higher energy prices come in the form of higher real wages and there is a wage-price spiral like we had in the 1970s? How would this affect my portfolio and how would it change my investments if it happened?

US Inflation, 1971 to 2021

Chart showing inflation in the US, from 1971 to 2021
Source: Bloomberg

And then, once I’ve thought about all that, I do something else. I think about why the scenario that I think won’t happen shouldn’t happen. This is where it gets difficult. Our natural impulse is to just dismiss potential developments that contradict our preconceived notions without much examination. Our instinct is to wave our hands and assume that things are always back to normal after an abnormal period. In a sense, I think inflation will return to pre-pandemic normalcy, while those who expect inflation to spiral out of control anticipate a normalcy reminiscent of the 1970s and 1980s.

But remember: there is no law of gravity in finance. A constant theme over my last three years writing about finance has been how the world has changed substantially since the Global Financial Crisis (GFC). Things don’t work the way they did in the 80s or 90s, let alone the 70s.

So I have to force myself to explain how things will work and back it up with data, not anecdotes. And I challenge you to do the same with your opinions and expectations. Don’t make your case with anecdotes or fall into other rhetorical traps, slippery slope arguments, and the like: “If we let this happen and don’t fight inflation now, it will entrench itself and spiral out of control.” You will lose credibility in my eyes and I will file your opinions in the drawer called “Ideologist”.

My golden rule is to rule out an outcome only if you can demonstrate beyond a reasonable doubt why it cannot happen. If you can’t, consider the possibility that you’re wrong and what it could mean for your investments.

By now, many of you are smiling. Because? Because my view that inflation will be transitory is the one that gets the most rejection from investors these days. Contrary to economists, the consensus among professional investors appears to be that the inflation outlook will worsen next year.

US Cyclically Adjusted PE Ratio (CAPE).

But here’s something to think about: If you’re convinced that inflation and interest rates will reverse a decades-long trend and begin a prolonged rally, you also have to believe that stock markets are significantly overvalued. Hundreds of charts, especially the Cyclically Adjusted PE (CAPE) ratio popularized by Robert Shiller, show how the US stock market soared into overvalued territory long ago.

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Many investors have sounded the alarm: current valuations are unsustainable and must come down. This has been his comeback for over a decade. And they’ve been wrong for over a decade.

So my question about the US downgrade is: What if they don’t?

For more information from Joachim Klement, CFA, don’t miss out Risk profile and tolerance i 7 mistakes every investor makes (and how to avoid them) and subscribe to his regular comment a Klement on investment.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / gremlin

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Joachim Klement, CFA

Joachim Klement, CFA, is a trustee of the CFA Institute Research Foundation and provides regular commentary to Klement on investment. He was previously CIO at Wellershoff & Partners Ltd., and before that, Head of the Strategic Research Team at UBS Wealth Management and Head of Equity Strategy at UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich (Switzerland) and Madrid (Spain), graduating with a master’s degree in mathematics. In addition, he has a master’s degree in economics and finance.

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